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May 28, 2020

UK Financial Conduct Authority Outlines Expectations for Managing Enhanced Market Conduct Risks in the Context of the Pandemic

Click for PDF  On 27 May 2020, the UK Financial Conduct Authority (the “FCA”) published Market Watch 63 (“MW63”). MW63 highlights that market participants (including issuers, their advisers and all other market participants) may be subject to new and emerging market conduct risks as a result of the current increase in primary market activity and working from home arrangements widely mandated as a result of public policy to deal with the COVID-19 pandemic. It then sets out the FCA’s expectations on market participants in terms of identifying and mitigating those risks in the current environment. It is clear that while we have seen some limited regulatory forbearance from the FCA in certain areas in order to alleviate operational burden on market participants and the markets, there is no room for reducing risk appetites or anything other than strict adherence to rules and regulatory expectations in the context of market conduct. The FCA acknowledges the current challenges faced by market participants during the crisis, however the expectation remains that all continue to act in a manner that supports the integrity and orderly functioning of financial markets. As a warning, the FCA also stressed that it will continue to use the tools at its disposal to monitor, investigate and (as necessary) take enforcement action to ensure that requirements relating to market conduct are complied with. This bulletin outlines the messages of MW63 and provides some practical guidance on the steps that market participants might take in order to ensure they meet the FCA’s expectations in the current environment. Considerations for all market participants The market conditions created by COVID-19 are giving rise to new challenges and considerations for all market participants attempting to manage their risks around identifying, handling and disclosing inside information for the purposes of Regulation 596/2014/EU on market abuse (“MAR”). This is a result of several factors, including (i) an increased number of capital raising events leading to greater flows of inside information; and (ii) existing systems and controls to restrict flows of inside information may not address working from home arrangements. In previous Market Watch newsletters[1], the FCA highlighted the importance of relevant firms undertaking a comprehensive risk assessment to identify the market abuse risks to which they are or may be exposed and the controls necessary to mitigate those risks. Firms are strongly advised to revisit those risk assessments in response to the Coronavirus pandemic and update them to reflect new and emerging risks, and to modify or enhance their systems and controls, including surveillance techniques, to ensure they remain adequate and effective, especially in light of the working from home environment and the heightened risk environment. The new types of risk which market participants may be exposed to include unlawful disclosure of inside information, as well as manipulative behaviour stemming from short selling activities. The FCA specifically addresses risks arising from short selling activity and makes it clear that the FCA will focus monitoring efforts on short selling activities in the secondary markets as part of its market monitoring. While the FCA does not specifically say so, it is clear when reading between the lines that the FCA is concerned that there is some evidence of abusive behaviour. The FCA will not shy away from bringing appropriate criminal or regulatory action where this is justified. Some firms are experiencing increased numbers of surveillance alerts as a result of increased market volume and volatility. It is key that firms address this operational challenge by tailoring their response to the risks they are exposed to and ensuring that the response does not diminish the appropriateness and effectiveness of surveillance techniques. Firms may need to consider conducting retrospective reviews concentrating on areas of heightened risk. Some specific issues raised Short selling In terms of compliance by market participants with their obligations under Regulation 236/2012/EU on short selling and certain aspects of credit default swaps (“SSR”), the FCA reminds market participants that they must, at all times, comply with: the prohibition on “naked” short sales; and the net short position reporting requirements. Where market participants engage in short selling activity, it would be prudent for them to confirm that their cover arrangements remain appropriate and that they have adequate documentary evidence of their compliance with the cover requirements. Market soundings  The MAR market soundings regime was introduced to provide a framework for controlling inside information when market participants undertake wall-crossings. The intent of the regime is to provide protection from allegations of unlawful disclosure of inside information. However, in order for market participants to have the benefit of this protection, the framework set out under MAR must be correctly followed. It is possible that in the current working from home environment firms may find it harder to adhere to the framework rules. It would be prudent for market participants to review their market sounding procedures to ensure they remain adequate and effective in the current environment. In particular, market participants should consider the following: disclosing market participants should ensure that they are maintaining appropriate records of their interactions, for example, through the use of recorded lines or written minutes (and that those written minutes are approved by the receiving market participant); receiving market participants should be aware that the purpose of the sounding is for issuers to gauge interest in and views on the proposed transaction. The information relating to the proposed transaction should only be shared internally on a strict need-to-know basis to enable relevant individuals to provide the necessary input to the issuer and for no other purpose; and the FCA has previously recognised the benefit of the gatekeeper model[2]; receiving market participants should consider whether their chosen method of receiving soundings remains adequate in the current environment and whether instructions to sell-side market participants need to be updated. Personal account dealing Given the FCA’s concern around the heightened risks relating to inside information in light of the current market environment, it would be prudent for all firms to revisit their arrangements for personal account dealing to ensure they adequately address the enhanced risks of most staff currently working from home. Market participants should remind their employees of relevant policies and address in particular how the policies apply in the current environment. This is particularly advisable as a result of the concerns expressed by the FCA in its preceding Market Watch newsletter[3] in relation to firms’ controls relating to personal account dealing, as it is highly likely that the FCA will conduct further thematic work in this area in the future. To the extent that firms have not reviewed and enhanced their policies and procedures in this area in response to Market Watch 62, now would be an opportune time to do so. Considerations for issuers In the context of increased capital raising activities, the FCA has specifically addressed some of the risks faced by issuers. We have set out a summary of the risks and some of the practical steps that issuers should take in order to mitigate those risks in the current environment.  Types of heightened risks Practical steps to take Primary markets activity increases the amount of inside information Nature of the information that is material to a business’s prospects may have been altered in the context of the pandemic, e.g.: ability to resume business, changes in strategy, return-to-work plans, supply chains; future financial performance, such as access to finance and funding, including through government schemes, changes to dividends and buy-back schemes New information may be materially different from previous forecasts, etc. which have previously been publicly announced and may now be misleading to the market, e.g. missing previous forecast earnings, revenue or related KPIs and, if so, announcement of that information is unlikely to be able to be delayed Working from home may give rise to new risks of unlawful disclosure of inside information Working from home may give rise to new risks for ensuring confidentiality of inside information when delaying disclosure   Ensure that existing procedures, systems and controls remain adequate to identify items of inside information and enhance them if necessary Consider whether new information is inside information and whether disclosure is required Consider refresher training and compliance bulletins for relevant staff on the appropriate handling of inside information, their duties in relation to insider dealing and unlawful disclosure and risk mitigants in the context of working from home Consider how inside information is securely accessed, stored and communicated especially where disclosure is being delayed Where financial reporting deadlines are extended, consider whether any additional information needs to be published in the interim to ensure compliance with MAR Consult with advisers and keep contemporaneous and complete records of decisions taken regarding the disclosure of inside information Ensure insider lists are maintained and that inside information is only disclosed on a “need to know” basis in accordance with MAR Only delay disclosure when all the conditions in MAR are met, and only selectively disclose information where disclosure is necessary in the normal exercise of employment, a profession, or duties and is on a confidential basis When permitted to delay disclosure, ensure a leak announcement is prepared Be especially vigilant about the possibility of leaks and rumours Ensure announcements are verified as being complete and accurate and do not contain false or misleading information  ________________________    [1]   Market Watch 56 and Market Watch 58    [2]   Market Watch 58 and Market Watch 51    [3]   Market Watch 62 Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments.  For additional information, please contact your usual Gibson Dunn contacts or the following authors: Authors: Michelle Kirschner, Martin Coombes, Chris Hickey, Patrick Doris, Steve Melrose and Chris Haynes © 2020 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
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May 28, 2020

General Court Dismantles European Commission’s Tough Approach to Mobile Mergers

Click for PDF General Court Judgment of 28 May 2020 - Case T-399/16, Case CK Telecoms UK Investments Ltd. v. Commission The General Court earlier today called into serious question the tough approach taken by the European Commission (the ‘Commission’) in its review of mergers in the mobile communications sector. In doing so, the General Court has subjected the Commission’s analysis to an unprecedented level of scrutiny on a range of important substantive issues, rather than seeking to catch out the Commission on more procedural technicalities. As noted by the General Court itself, this was the first time it had been called upon to rule on the conditions for the application of the EU Merger Regulation to a merger in an oligopolistic market which did not involve the creation or strengthening of an individual or collective dominant position, but giving rise to so-called “non-coordinated effects”.[1] Since its initial 2006 Decision in T-Mobile Austria/Tele-ring,[2] the Commission has focused on a series of “gap” cases[3] in mobile communications markets, rather than on traditional theories of harm based on unilateral effects. The overturning of a Commission merger veto Decision is rare,[4] and it is even more rare for a General Court Ruling to annul a Commission Decision is such a comprehensive manner. The Decision The appeal arose in relation to the Commission’s 2016 Decision[5] to block the proposed acquisition by UK mobile network operator (‘MNO’) Three of O2, thereby limiting the number of MNOs on the UK market from 4 to 3. The acquisition would have created the UK’s largest MNO, with a market share of 40%. In the eyes of the Commission, the loss of a fourth MNO in the circumstances was incompatible with the Common Market. It was generally understood at the time that the Commission’s Decision was fully endorsed by the UK authorities, which had earlier requested that the merger be reviewed by them under the ‘referral’ powers available under the EU Merger Regulation.[6] The key findings of the Commission's Decision were that the proposed transaction would result in the following: A lessening of competition due to the removal of an important competitor, leaving only two other MNOs (namely, Vodafone and Everything Everywhere, or ‘EE’) to compete against the merged entity. This would have lowered existing incentives on the merged entity to compete, in turn leading to higher prices and reduced quality and choice for consumers. The hampering of mobile network infrastructure investment in the UK, primarily because the merged entity would have been participating with two other sets of infrastructure sharing agreements with the other MNOs on the market. The level of market transparency gained by participation in such agreements was likely to lead to less competition in the roll-out of next generation (5G) technology. A reduction in the number of MNOs that would be willing to host mobile virtual network operators (“MVNOs”) through wholesale access relationships, thereby weakening the negotiating position of MVNOs to obtain favourable access terms from MNOs. With a view to overcoming the Commission’s competition concerns reflected in its three theories of harm, the notifying parties submitted a series of proposed behavioural commitments to the Commission concerning the grant of MVNO access and access to its network sharing relationships. These commitments were rejected by the Commission because they were too complex to implement and to monitor effectively, and because they would have been commercially unattractive to MVNOs. Grounds of the Appeal The appeal before the General Court was based on a number of grounds, including the Commission’s alleged errors of assessment when concluding that the merging parties were “close competitors” and when concluding that Three was an “important competitive force” in the mobile wholesale access market. In addition, it was argued that the Commission had misunderstood important aspects of Three’s network capacity capabilities relative to its competitors. It was also argued that the Commission had misunderstood the workings of the UK mobile market when concluding that the MNOs were likely to align their market behaviour post-merger. Finally, it was alleged that the Commission had erred in concluding that the commitments offered by the notifying parties were not capable of sustaining effective competitors in the marketplace. The Judgment In what might be seen to be a landmark Judgment, the General Court annulled the Commission’s Decision in its entirety, concluding that the Commission had failed to substantiate its three separate theories of harm laid out in its Decision. According to the General Court, the Commission had failed to satisfy the requisite legal standard regarding the negative effects of the proposed merger on prices and quality, the competitive impediments raised by the network sharing agreements, and the concerns about wholesale access bargaining. More specifically, the Court subjected each of the Commission’s theories of harm to forensic analysis. Thus, in connection with the first theory of harm, the Court was not convinced that a relatively low degree of product differentiation was likely to eliminate competitive constraints being exercised in the mobile retail market. Moreover, the Commission’s quantitative analysis had little probative value, as it fell far short of proving how “significant” the upward pressure on retail prices would be. To add insult to injury, the Court felt that the Commission had wrongly conflated the ideas of “significant impediment to effective competition”, “elimination of an important competitive constraint” and “elimination of an important competitive force”. In doing so, it rendered its decision-making on the first theory of harm fatally flawed. As regards the second theory of harm, the Court expressed its surprise at the “novelty” of that theory, insofar as the Court found it difficult to comprehend how the Commission could draw a causal link between potential increases in fixed and incremental costs with a tendency of MNOs to engage in fewer network investments, deteriorate quality or lower competitive pressure. Moreover, in asserting that new levels of transparency between operators would induce aligned behaviour, the Commission had failed to conduct a sufficiently dynamic analysis of current and emerging competitive conditions. Most importantly, the Commission had failed to give due weight to the fact that, at some time post-merger, the merging parties would be operating only one network, which would by definition weaken any tendency towards greater transparency in the market. Finally, the Court also dismissed the Commission’s third theory of harm. According to the Court, the Commission had over-emphasised the extent to which the competitive dynamic might change as a result of 4 access options being diminished to 3. Moreover, the Commission had over-estimated the relative importance of Three in the wholesale market, where it accounted for only a relatively small market share. As such, its disappearance as a wholesale access option was unlikely to change the competing environment in any significant way post-merger. The views of the General Court will no doubt make unpleasant reading for the Commission, yet it is difficult to find fault with the approach adopted by the Court. Given the number of methodological errors made by the Commission, it would be wrong to conclude that the General Court has gone beyond its review mandate and superimposed its views for those of the Commission on matters of complex economic assessment. There now seems to be a clear current of thinking in the General Court that the Commission is under a significant responsibility to explain it’s sometimes complex economic analyses. This is most obvious when it comes to likely competitive effects, but has also recently been seen in relation to other issues like fine calculations. Likely Aftermath It is undeniable that the Commission has suffered a significant blow to its tough policy on “gap” mergers in the mobile communications sector. The mobile industry will no doubt be heartened that the General Court has dealt a blow to that policy, as the industry continues to explore the possibilities of consolidation in the face of tough margins and competition from “over the top” providers of communications services. The mobile industry will be particularly pleased by the fact that the General Court has, on a number of occasions in its Judgment, pointed out that there is no competitive magic associated with the existence of 4 mobile operators in any given national market. Despite numerous denials to the contrary by Commission spokespeople,[7] the overwhelming feeling has been for some time that the Commission has operated under the mantra that the existence of 4 mobile operators in each Member State is the preferred market structure that will deliver optimal competitive outcomes. The industry will also be well disposed to the views expressed by the Court about the motivations on the industry to invest as an outcome of consolidation, rather than using consolidation to engage in less ambitious expansion plans. In this sense, it must also provide a spur to the industry that its members now have the prospect of achieving scale at a pan-European level on the cusp of next generation 5G investments being made that will provide the bedrock for Europe’s digital transformation in the age of the “Internet of Things”.[8] Having said all that, a 4-to-3 mobile deal will still pose great challenges for the notifying parties. With one notable exception,[9] the Court has focused fundamentally on the faulty methodology relied upon by the Commission, rather than on the analytical basis of the theories of harm adopted by it.[10] Moreover, the Court has not needed to take a view on the Commission’s tough line on remedies, as this question was rendered moot in the circumstances. Armed with the ability to extract comprehensive commitments from the notifying parties to a merger, it is arguable that the Ruling of the Court has merely clipped the Commission’s wings, rather than having dealt it a bodyblow. The next merger in the mobile sector may therefore be a tough test case in the wake of the Court’s Ruling, as the Commission re-assesses its position and the depths of its fact-finding. Finally, the net beneficiaries of this Judgment are likely to be the parties negotiating the proposed Virgin Media/O2 deal, which will be facing merger review bodies across the Channel bearing deep scar tissue from their recent mauling before the General Court in the Three/O2 Case.[11] _________________________ [1] Guidelines on the assessment of horizontal mergers under the Council Regulation on the control of concentrations between undertakings, OJ C 31, 5.2.2004, pp. 5-18, paragraphs 24-38. [2] Case No. COMP/M.3916. [3] In complex oligopoly situations, theories of harm are developed to address theories of harm in the analytical “gap” that exists between unilateral effects and coordinated effects theories. [4] Since the adoption of the EU Merger Regulation in January 2004, the Commission has blocked only twelve mergers following a “Phase II” investigation on the basis of Article 8(3) of the Regulation. Among these, eight appeals were brought before the General Court, and three are still pending. [5] Case No. COMP/M.7612. [6] Council Regulation (EC) No. 139/2004 of 20 January 2004 on the control of concentration between undertakings, OJ L 24, 29.1.2004, pp. 1-22, Article 9(2)(a). [7] See, for example, most recently, Olivier Guersent’s statement according to which Telecoms mergers that leave just three players do not face a pre-cooked veto from Brussels (April 2020), available at: https://www.mlex.com/GlobalAntitrust/DetailView.aspx?cid=1182698&siteid=190&rdir=1. [8] The Internet of things (“IoT”) is a system of interrelated computing devices that are provided with unique identifiers and the ability to transfer data over a network without requiring human-to-human or human-to-computer interaction. [9] Namely, the Commission’s conclusion that low levels of investments would be the necessary by-product of network sharing agreements. [10] Even as regards the application of the third theory of harm, there is nothing to suggest that the Commission’s views about the likely negative impact on bargaining power for mobile network access agreements would not have been upheld had Three enjoyed a more significant wholesale market share. [11] https://www.theguardian.com/business/2020/may/07/virgin-media-and-o2-owners-confirm-31bn-mega-merger-in-uk. Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments. For additional information, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Antitrust and Competition Practice Group, or the following authors in Brussels: Peter Alexiadis (+32 2 554 7200, palexiadis@gibsondunn.com) David Wood (+32 2 554 7210, dwood@gibsondunn.com) Iseult Derème (+32 2 554 72 29, idereme@gibsondunn.com) © 2020 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
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May 28, 2020

Update on Intellectual Property-Related Issues in the Response to COVID-19

Click for PDF This Alert reports on recent intellectual property law developments relating to the COVID-19 pandemic.  First, we describe a new pilot program of the United States Patent and Trademark Office (“USPTO”), intended to help small businesses obtain expedited review of patent applications on products and processes related to the battle against COVID-19, and the agency’s new platform listing COVID-19 related patents that are available for licensing.  Second, we discuss the World Health Assembly’s COVID-19 resolution calling on countries to rely on patent pooling mechanisms to help develop new technologies to fight the pandemic, and the response by the United States to sections of the resolution. (1) Two USPTO Initiatives Relating to the Fight Against COVID-19 The COVID-19 Prioritized Examination Pilot Program:  On May 14, 2020, the USPTO published a notice in the Federal Register setting forth the eligibility requirements for its previously announced “COVID-19 Prioritized Examination Pilot Program.”  That Pilot Program seeks to expedite the examination of patent applications that cover products or processes related to the fight against COVID-19.  The program, which is restricted to applicants that qualify for either “small entity” or “micro entity” status (pursuant to 37 C.F.R. §§ 1.27 and 1.29), permits such entities to request prioritized examination of patent applications without paying the fees typically associated with such a request.  (Notably, the “small entity” definition includes, among other things, “[a] university or other institution of higher education located in any country” and any Section 501(c)(3) organization that is exempt from taxation under Section 501(a) of the Internal Revenue Code).  While the goal of the prioritized examination under the program “is to provide a final disposition within 12 months, on average, from the date prioritized status has been granted,” the USPTO has stated that it will “endeavor to reduce” that timeframe to six months, if applicants respond within 30 days to “notices and actions” from the agency, once the applicant’s initial request to have its patent applications be considered for prioritized examination has been approved.[1] The pilot program will begin accepting requests for prioritized examination on July 13, 2020, and will continue “until such time as the USPTO has accepted a total of 500 requests.”[2]  To be eligible for the program, qualifying patent applicants must certify that at least one of the pending claims in the patent application(s) for which they seek expedited review is a product or process “subject to an applicable FDA approval for COVID-19 use.”  In addition, in what appears to be an effort to help ensure that the pilot program is limited to applicants seeking patents on more recent inventions, patent applications that claim the benefit of an earlier filing date of two or more U.S. non-provisional applications (or certain international applications) are ineligible for the program. As early commentators have noted, small businesses that qualify for the program will need to carefully weigh its potential benefits against the potential risks of seeking prioritized examination of patent applications within what could be a very short timeframe, given that the program is currently limited to 500 requests.  Although the program’s offer of a cheaper and faster process to apply for patents on inventions like COVID-19 vaccines may be enticing to smaller businesses—especially since patents can help attract further capital—the pressure to get one of the program’s limited slots could potentially lead to the filing of premature applications that require further experimental data and research in order to meet the requirements for patentability.  Small businesses will therefore need to consider whether their inventions are ripe enough to mitigate the possibility that applying for a patent too early will create an unfavorable prosecution record that could impede subsequent renewed efforts to patent those inventions. Patents 4 Partnerships:  Earlier this month, the USPTO created the “Patents 4 Partnerships” program, which is a platform that allows patent holders (and owners of published patent applications) relating to COVID-19 technologies to list such patents and applications if they are available for licensing.  The public can search the platform, including by keyword, issue date, and inventor name.  As described by Andrei Inacu, Undersecretary of Commerce for Intellectual Property and Director of the USPTO, Patent 4 Partnerships “is a meeting place that enables patent owners who want to license their IP rights to connect with the individuals and businesses who can turn those rights into solutions for our health and wellbeing.” Patent holders may list their patents on the platform using the Platform Submission Page.  As of May 26, 2020, the platform includes over 200 patents and published patent applications. (2)  The World Health Assembly’s COVID-19 Resolution Calls for Voluntary Patent Pooling During a virtual meeting last week, the World Health Assembly (“WHA”) passed a resolution pressing for intensified efforts to control the pandemic and seeking equitable distribution of the technologies and products necessary to do so.[3]  The resolution calls on international organizations “to work collaboratively at all levels to develop, test, and scale-up production” of “affordable diagnostics” and “vaccines for the COVID-19 response,” referencing “existing mechanisms for voluntary pooling and licensing of patents in order to facilitate . . . affordable access to them, consistent with the provisions of relevant international treaties[.]”   Existing mechanisms that can facilitate voluntary pooling and licensing of patents include the work of the U.N.-backed nonprofit “The Medicines Patent Pool.”  As reported in a prior alert, that Patent Pool gathers COVID-19 related patent information—such as on products that are tested in clinical trials to treat the virus—and makes that information accessible in a publicly available repository of patent data.  The World Health Organization reports that the WHA resolution is co-sponsored by more than 130 countries. The Resolution cautions that the cooperative efforts it advocates must all “respect” and “be consistent with” the provisions of the Agreement on Trade-Related Aspects of Intellectual Property Rights (“TRIPS Agreement”) and the Doha Declaration on the TRIPS Agreement and Public Health (“Doha Declaration”).[4]  See Resolution at ¶¶ 4, 8.2, 9.8. In a written statement, the United States Department of State “endorse[d] the call in the resolution for all Member States to provide the WHO with timely, accurate, and sufficiently-detailed public health information related to the COVID-19 pandemic,” but “disassociate[d]” itself from a number of paragraphs in the resolution, including some relating to intellectual property.  For example, the United States objected to paragraphs 4, 8.2, and 9.8 of the resolution.  The United States “disassociates” from those paragraphs because the language in those paragraphs referencing the TRIPS Agreement and the Doha Declaration “does not adequately capture all of the carefully negotiated, and balanced, language” in the TRIPS Agreement and Doha Declaration.  Likewise, the United States objected that those paragraphs “present[] an unbalanced and incomplete picture of that language at a time where all actors need to come together to produce vaccines and other critical health products.”  Finally, the United States emphasized that “[i]t is critical” that the “existing mechanisms for voluntary pooling” of patents referenced in the resolution “be narrowly tailored in scope and duration to the medical needs of the current crisis[.]” We are continuing to monitor developments that may be of interest to businesses who hold, or seek to use, intellectual property rights. ____________________    [1]   COVID–19 Prioritized Examination Pilot Program, 85 Fed. Reg. at 28933 (May 14, 2020).    [2]   Id.    [3]   The WHA, which is comprised of delegations from all WHO Member States, acts as the WHO’s decision-making body, principally determining the WHO’s policies, and appointing the Director-General.    [4]   At the risk of oversimplification, the TRIPS Agreement, which became effective on January 1, 1995, is a multilateral agreement that principally sets forth minimum standards of protection to be provided by Member countries to various types of intellectual property.  The Doha Declaration of 2001 was adopted in response to growing concerns that patent-related terms under TRIPS Agreement could restrict access to affordable medicines in developing countries.  The Declaration endeavored to allay those concerns by, for example, giving each Member the right to grant compulsory licenses (i.e., without the consent of patent holders) to the use of their patented inventions. Gibson Dunn lawyers regularly counsel clients on the issues raised by this pandemic, and we are working with many of our clients on their response to COVID-19.  For additional information, please contact any member of the firm’s Coronavirus (COVID-19) Response Team.  Please also feel free to contact the Gibson Dunn lawyer with whom you usually work, or the authors: AUTHORS:  Joe Evall (jevall@gibsondunn.com), Richard Mark (rmark@gibsondunn.com), Doran Satanove (dsatanove@gibsondunn.com), and Amanda First (afirst@gibsondunn.com) © 2020 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
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May 27, 2020

Key Considerations for Issuers and Auditors Regarding Going-Concern Analysis

Click for PDF Issuers in the United States and their auditors have related, but distinct, obligations to evaluate on a periodic basis whether there is substantial doubt about the issuer’s ability to continue as a going concern.[1]  In normal times, this evaluation, conducted with an appropriate level of diligence, results as to almost all major public companies in the conclusion that there is no substantial doubt about the entity’s ability to meet its obligations in the months to come. But these are not normal times.  As the COVID-19 crisis takes an ever-greater toll on the American economy, and as multiple well-known companies declare bankruptcy,[2] the going-concern assessment has taken on new relevance for issuers, auditors, and others in the financial-reporting community.  As a result, the number of issuer filings that contain a going-concern disclosure appears to have substantially increased.[3]  In this piece, we review some of the significant considerations that apply to the going-concern analysis from both the issuer’s and the auditor’s perspectives. Summary of Issues Financial Accounting Standards Board (“FASB”) accounting standards and PCAOB auditing standards both require an assessment of whether there is substantial doubt about the issuer’s ability to continue as a going concern, including evaluating concrete management plans to address the circumstances giving rise to the reasonable doubt. The auditor is required to make an independent assessment, not simply evaluate management’s process. Important differences between the accounting and auditing standards include that the management assessment occurs quarterly and looks forward one year from the date the financial statements are issued, whereas the auditor annually considers the period one year from the balance sheet date, with different quarterly review procedures. Both auditors and issuers should anticipate potential exposure to regulatory and private litigation should their forecasts of the effects of the COVID-19 pandemic prove inaccurate. Background American Institute of Certified Public Accountants (“AICPA”) and, later, PCAOB auditing standards have for decades required auditors to evaluate on an annual basis whether there is substantial doubt about the ability of the audited entity to continue as a going concern.[4]  Under current PCAOB standard AS 2415, an auditor assesses, based on the relevant information obtained during the audit,[5] whether substantial doubt exists about the entity’s ability to meet its obligations as they come due over a reasonable period of time after the balance sheet date (not to exceed one year in the future) without the entity’s having to resort to measures such as disposing of significant assets or restructuring its debt.[6]  The relevant information could include evidence such as negative operating trends, loan defaults, loss of key customers or patents, or even natural disasters.[7]  If the auditor concludes that substantial doubt does exist, then as a second step it is required to consider management’s plans to address the circumstances giving rise to the substantial doubt, such as selling assets, restructuring debt, or raising capital.  Under AS 2415, the auditor’s focus is on whether those plans are feasible and whether the assumptions underlying them are reasonable, such that they represent an adequate plan to address the circumstances.[8]  If the auditor concludes even after assessing management’s plans that substantial doubt about the entity’s ability to meet its obligations over the coming year still exists, then the auditor must, among other steps, include an explanatory paragraph to that effect in the audit report.[9] In addition, if an auditor, during an interim review of an entity’s quarterly financial statements, becomes aware of “the entity's possible inability to continue as a going concern,” the auditor is required to make certain inquiries of management and assess whether management’s disclosures are adequate.[10] On top of this established framework, the FASB in 2014 adopted a requirement that companies make their own assessments on a quarterly basis of their ability to continue as a going concern, a requirement codified as ASC Subtopic 205-40.[11]  Subtopic 205-40 differs from the PCAOB’s AS 2415 in some important ways.  For example, unlike the PCAOB, the FASB defined the concept of “substantial doubt” in connection with its standard: specifically, it stated that substantial doubt exists as to an entity’s ability to continue as a going concern “when conditions and events, considered in the aggregate, indicate that it is probable that the entity will be unable to meet its obligations as they become due within one year after the date that the financial statements are issued.”[12]  In other respects, Subtopic 205-40 bears close similarities to AS 2415, including in the circumstances that can indicate that substantial doubt exists and in the requirement to assess management plans to alleviate the substantial doubt.[13] Even apart from the considerations specific to the COVID-19 crisis, there are two differences between Subtopic 205-40 and AS 2415 that are important to bear in mind: First, management’s disclosure obligations differ from those of the auditor. While the auditor’s disclosure consists of an explanatory paragraph in the audit report,[14] management’s disclosure of substantial doubt about its ability to continue as a going concern is found in the notes to the financial statements and management typically also includes disclosure of the issue in the liquidity section of management’s discussion and analysis (“MD&A”), as well as in the issuer’s risk factors.[15]  Additionally, under Subtopic 205-40, where an issuer that concludes that management’s plans have alleviated the substantial doubt about its ability to meet its obligations, the issuer still must disclose in the notes to the financial statements that substantial doubt existed in the absence of those plans.[16]  AS 2415, on the other hand, does not require disclosure by the auditor in situations where management’s plans have alleviated the substantial doubt. Second, while management’s obligation to evaluate its going-concern status is identical at the annual and quarterly stages,[17] the auditor’s obligations vary considerably between year-end and quarter-end. Unlike many audit procedures, in which the auditor evaluates the reasonableness of management’s accounting or disclosures, the annual going-concern analysis represents a standalone process for the auditor to arrive at a conclusion regarding the entity’s status.[18]  In an interim review, by contrast, the procedures are both more limited and more tied to management’s assessment.[19] Although global pandemics were not included on the list of adverse conditions in either AS 2415 or Subtopic 205-40, the economic shock that COVID-19 has created will provide a basis for many companies and auditors to conduct a more searching going-concern analysis than usual in the months to come.  As we address in the next section, this analysis will be especially difficult in a crisis such as COVID-19 whose duration and economic effects are so unpredictable.  We will then address some other key considerations for issuers and auditors as they assess the potential for substantial doubt to exist concerning management’s ability to meet upcoming obligations. Addressing the Significant Uncertainty of the COVID-19 Crisis The list of adverse events set out in AS 2415 and Subtopic 205-40 that could potentially call a company’s viability into question includes items such as negative operating trends, work stoppages, and loan defaults.[20]  In some cases, the ultimate outcome of those events or circumstances will be uncertain at the time of management’s or the auditor’s assessment.  The COVID-19 pandemic, however, raises a set of global uncertainties—concerning areas from public health to financial markets—whose complexity is an order of magnitude greater than that of the circumstances that may drive an entity’s going-concern analysis in normal times. While Subtopic 205-40 requires only that an entity assess its ability to meet its obligations based on “relevant conditions and events that are known and reasonably knowable at the date that the financial statements are issued,”[21] and AS 2415 similarly requires only that the auditor consider “his or her knowledge of relevant conditions and events that exist at or have occurred prior to the date of the auditor's report,”[22] both issuers and auditors should be aware that regulators and private plaintiffs will later assess their actions with twenty-twenty hindsight.  Plaintiffs, in particular, will have an incentive to ignore that the auditor “is not responsible for predicting future conditions or events,”[23] and likely will seek to claim that the events of the next year were clearly on the horizon at the time that companies and auditors issued their financial statements and reports, based on the progression of the COVID-19 crisis as of that time.  In assessing the risk that an entity will be unable to meet its obligations in the coming months, both issuers and auditors should anticipate that they will face potential legal exposure for failing to accurately predict the future. In the current environment, both management and auditors are likely best served by: (i) making, documenting, and disclosing a good-faith attempt to identify the operational, financial, and economic factors that will affect the company’s ability to meet its obligations in the coming year, including those that are likely to indicate a worse outcome for the company; (ii) comprehensively documenting what they believe is known and reasonably knowable, as of their assessment date, about the implications of each factor for the company’s ability to meet its obligations in the coming months—including, as appropriate, based on consultation with third-party experts such as outside counsel or valuation experts; and (iii) making, and documenting, a good-faith assessment, based on that forecast, of how likely it will be that a point arrives within the relevant timeframe at which, individually or in the aggregate, one or more of those factors causes the company to be unable to meet its obligations as they come due. Other Key Considerations In addition to the problem of uncertainty in the progression of the COVID-19 crisis, there are other considerations that issuers and auditors should bear in mind as they conduct their going-concern assessments. First, if an entity’s management concludes that substantial doubt exists concerning its ability to meet its obligations absent management plans to address the situation, then management should keep in mind the requirements that apply to the plans that it develops. Subtopic 205-40 makes clear that substantial doubt about an entity’s ability to continue as a going concern is alleviated only if two conditions are met: (i) “It is probable that management’s plans will be effectively implemented within one year after the date that the financial statements are issued,” and (ii) “It is probable that management’s plans, when implemented, will mitigate the relevant conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are issued.”[24] Concerning the first condition, the standard states that for management’s plans to be considered probable for implementation, they generally must already have been approved by management at the time the financial statements are issued.[25]  That is, they should generally not be merely theoretical or even under active consideration.  This means that, if management anticipates that its quarter-end analysis may lead to an initial conclusion that substantial doubt exists concerning its ability to continue as a going concern, it should take anticipatory steps during the quarter to plan its response, to help ensure that it has time to approve any alleviating plans that may become necessary. Concerning the second condition, Subtopic 205-40 states that the magnitude and timing of management’s plans must be measured against “the magnitude and timing of the relevant conditions or events that those plans intend to mitigate.”[26]  If, for example, management adopts a plan to address its liquidity needs that will not become effective until after the principal period of its liquidity shortfall has passed, then it may be difficult for it to conclude that the plan is effectively timed to alleviate the substantial doubt concerning its ability to meet its obligations.  Issuers should try to ensure, therefore, that they develop plans that will realistically meet their expected liquidity and related needs in terms of both timing and magnitude. Management should remain aware as to both of these conditions that the probability of execution or success that it assigns to its plans may differ from the probability that its auditor assigns to those same plans; thus, if it hopes to avoid a going-concern explanatory paragraph in the audit report, it will need to communicate early and often with the auditor to understand the auditor’s views as to how it anticipates evaluating management’s plans. Second, PCAOB standards similarly prescribe particular considerations should an auditor initially conclude that substantial doubt about the entity’s ability to continue as a going concern does exist such that management’s plans become relevant.  AS 2415 directs the auditor to focus especially on two points: (i) “those elements that are particularly significant to overcoming the adverse effects of the conditions and events,” and (ii) any “prospective financial information [that] is particularly significant to management's plans.”[27]  The standard requires the auditor to obtain audit evidence specifically to address the most significant aspects of management’s plan, including the evidence that supports management’s assumptions about the prospective financial effects of its plans.  This information should be considered with appropriate professional skepticism, and the auditor should keep in mind that the PCAOB would likely conclude that the provisions of auditing standards that require an auditor to consider contrary audit evidence would apply to this exercise.[28] Third, complications may arise even after the annual audit if the issuer intends to incorporate by reference its financial statements with the Securities and Exchange Commission (“SEC”) as part of a registered offering conducted pursuant to the Securities Act of 1933, as amended.  If the issuer does incorporate its financial statements by reference, the issuer is required to obtain the auditor’s consent to include the audit report as part of the registered offering.  PCAOB standards require auditors to conduct certain procedures in that situation,[29] and if as a result of those procedures the auditor determines that its audit report would be misleading in the absence of a going-concern explanatory paragraph (even though the conditions giving rise to the substantial doubt occurred after the issuance of the report), then the auditor might re-issue its audit report to include a going-concern explanatory paragraph and require that the issuer update its financial statements to reflected this added disclosure.  Depending on the timing, this re-issuance may or may not occur in conjunction with the issuer’s conducting its own quarterly evaluation of its ability to continue as a going concern. Fourth, there is a slight discrepancy between the time period applicable to an issuer’s going-concern analysis and that applicable to the auditor, but the period during which both parties obtain the evidence that is relevant to their analysis is the same. AS 2415 states that the auditor’s going-concern evaluation is conducted with reference to the balance-sheet date; meanwhile, Subtopic 205-40 states that management’s evaluation should occur as of the date the financial statements are issued.[30]  FASB noted in adopting Subtopic 205-40 that it had received input “from many auditors indicating that, in practice, they already assess over a period of one year from the audit report date instead of one year from the balance sheet date.”[31]  More importantly, however, AS 2415 makes clear that the auditor’s consideration of the going-concern question must be “based on his or her knowledge of relevant conditions and events that exist at or have occurred prior to the date of the auditor's report.”[32]  The fact that the auditor’s balance-sheet date is used as a reference date, then, does not provide the auditor with an excuse to ignore subsequent events that occur prior to the audit report. A recent SEC case addressing an auditor’s going-concern analysis demonstrated this fact in practice.  In the Matter of the Application of Cynthia C. Reinhart, CPA was an appeal to the SEC from sanctions that the PCAOB had ordered be imposed on the engagement partner for an audit of a mortgage lender, Thornburg Mortgage, Inc. (“Thornburg”).[33] The PCAOB charged that Ms. Reinhart had, among other things, failed to properly assess whether there was substantial doubt about Thornburg’s ability to continue as a going concern.  Although the SEC recognized that Ms. Reinhart and her team had, consistent with AS 2415, assessed the question of substantial doubt over a period lasting until the following fiscal year end, the SEC’s discussion of the sufficiency of her assessment concentrated in large part on events that occurred between the balance-sheet date and the report date, such as fluctuations in Thornburg’s ability to meet margin calls leading up to the filing of its Form 10-K.[34]  The Reinhart case is a useful reminder that the difference between management’s and the auditor’s reference date does not create any distinction between them in terms of the available evidence that may affect their assessment. Fifth, it has been discussed that auditors may be concerned about issuing going-concern opinions in part because doing so could accelerate the financial decline of the entity being audited, such that the going-concern paragraph becomes a self-fulfilling prophecy.[35]  Given the widespread economic dislocations that the COVID-19 crisis has caused, there may be reason to think that the stigma of a going-concern opinion is not as acute as it has been under normal circumstances.  In either case, however, audit engagement teams should keep in mind that protecting their own, and their firms’, interests depends on the team ensuring that it considers the relevant evidence with appropriate skepticism and documents that its process was thorough and appropriate. Sixth, issuers should seek counsel sooner rather than later about their fiduciary obligations when potential going-concern issues exist because it is critical that officers and directors fully understand their fiduciary obligations and how best to comply with them and make reasoned, disinterested, good faith decisions that receive the benefit of the business judgment rule.  Members of the Firm’s Business Restructuring and Reorganization Group can assist officers and directors to understand and comply with these obligations. Conclusion Hopefully, the period when going-concern analyses occupy a heightened level of attention will pass in the coming months as the COVID-19 health crisis wanes and the U.S. and world economies rebound.  Until that time comes, issuers and auditors should ensure that they are approaching the going-concern analysis with the care that it will now warrant. ____________________________    [1]   This alert focuses on the considerations applicable to issuers who report their financial statements on the basis of U.S. Generally Accepted Accounting Principles and to audits of those issuers performed pursuant to Public Company Accounting Oversight Board (“PCAOB”) auditing standards.  We note, however, that International Financial Reporting Standards (“IFRS”) also contain a requirement that an entity assess its status as a going concern.  See IAS 1.25, Presentation of Financial Statements.  As a result, many of the observations contained herein may also be relevant to issuers who report using IFRS.    [2]   See, e.g., Hertz Global Holdings, Inc., Form 8-K filed May 26, 2020; J. C. Penney Co., Inc., Form 8-K filed May 18, 2020; J.Crew Group, Inc., Form 8-K filed May 4, 2020.    [3]   Among the companies that have recently issued going-concern notices are: Chesapeake Energy Corp., see Form 10-Q filed May 11, 2020; and Dave & Buster’s Entertainment, Inc., see Form 10-K filed Apr. 3, 2020.  See also SandRidge Energy, Inc., Form 10-Q filed May 19, 2020 (disclosing substantial doubt concerning ability to continue as a going concern alleviated by management plans to sell headquarters).    [4]   See AU § 341, The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern.  AU Section 341 was adopted as an interim standard by the PCAOB pursuant to PCAOB Rule 3200T, see PCAOB Rel. No. 2003-006 (Apr. 18, 2003), and is now codified in PCAOB auditing standards as AS 2415, Consideration of an Entity’s Ability to Continue as a Going Concern.    [5]   AS 2415 does not require any procedures to be performed solely for purposes of the going-concern evaluation.  Instead, it contemplates that “[t]he results of auditing procedures designed and performed to achieve other audit objectives should be sufficient for that purpose.”  AS 2415.05.    [6]   AS 2415.01-.03.    [7]   AS 2415.06.    [8]   AS 2415.07-.09.    [9]   AS 2415.12.   [10]   AS 4105.21, Reviews of Interim Financial Information.   [11]   See Accounting Standards Update No. 2014-15, Disclosure of Uncertainties About an Entity’s Ability to Continue as a Going Concern (Aug. 2014) (“ASU 2014-15”).   [12]   ASU 2014-15, Glossary (emphasis in original, other emphasis removed).  FASB made clear that the term “probable” as used here has the same meaning as it does in the context of assessing loss contingencies under ASC Topic 450. See id. In the relevant contingencies standard, FASB defined “probable” to mean that “[t]he future event or events are likely to occur.”  See Statement of Financial Accounting Standards No. 5, Accounting for Contingencies, ¶ 3(a).  Although the standard does not assign percentages to this term, practitioners generally note that “probable” represents approximately a seventy percent chance or greater of occurrence.  See, e.g., A Roadmap to Accounting for Contingencies and Loss Recoveries, at 21 (Deloitte 2019).   [13]   See ASC 205-40-55-2 (using same list of adverse conditions as that used by PCAOB); ASC 205-40-50-6 (consideration of management plans).   [14]   See AS 2415.12.   [15]   See ASC 205-40-50-13 (requiring both footnote disclosure and “information that enables users of the financial statements to understand” three points: (i) the “[p]rincipal conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern”; (ii) “[m]anagement’s evaluation of the significance of those conditions or events in relation to the entity’s ability to meet its obligations”; and (iii) “[m]anagement’s plans that are intended to mitigate the conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern”).   [16]   Specifically, management’s disclosures must include (i) the “[p]rincipal conditions or events that raised substantial doubt about the entity’s ability to continue as a going concern (before consideration of management’s plans)”; (ii) “[m]anagement’s evaluation of the significance of those conditions or events in relation to the entity’s ability to meet its obligations”; and (iii) “[m]anagement’s plans that alleviated substantial doubt about the entity’s ability to continue as a going concern.” ASC 205-40-50-12.   [17]   In adopting ASU 2014-15, FASB explicitly stated that it considered limiting the going-concern analysis to an annual exercise but elected to adopt a quarterly requirement instead, “to ensure that uncertainties about an entity’s ability to continue as a going concern were being evaluated comprehensively for each reporting period, and being reported timely in the financial statement footnotes.”  ASU 2014-15, ¶ BC23.   [18]   In the wake of FASB’s adoption of Subtopic 205-40, the PCAOB staff issued a release emphasizing that an issuer’s “determination that no disclosure is required under [applicable accounting principles] is not conclusive as to whether an explanatory paragraph is required” under PCAOB standards.  PCAOB Staff Audit Practice Alert No. 13, Matters Related to the Auditor’s Consideration of a Company’s Ability to Continue as a Going Concern (Sept. 22, 2014).  The exception to the principle in AS 2415 that the auditor is in a proactive rather than reactive position in conducting its annual assessment is that, should the entity determine that substantial doubt exists, then the auditor is required to assess the reasonableness of management’s disclosures on that point.  See AS 2415.10-.11.   [19]   See AS 4105.21.   [20]   See ASC 205-40-55-2; AS 2415.06.   [21]   ASC 205-40-50-3.   [22]   AS 2415.02.   [23]   AS 2415.04.   [24]   ASC 205-40-50-7.   [25]   See ASC 205-40-50-8.   [26]   ASC 205-40-50-10.   [27]   AS 2415.08-.09.   [28]   See AS 1105.29, Audit Evidence (requiring auditor to perform procedures to address any inconsistency or lack of reliability in the audit evidence it obtains).  As an example, the SEC in the Reinhart matter (see infra note 33) considered in connection with Ms. Reinhart’s going-concern analysis the predecessor standard to AS 1105, which likewise directs an auditor to “consider relevant evidential matter regardless of whether it appears to corroborate or to contradict the assertions in the financial statements.”  AU 326.25, Evidential Matter.  In its order, the SEC appeared to assume that Ms. Reinhart was required to consider inconsistent audit evidence as well as confirmatory evidence when assessing the issuer’s ability to continue as a going concern.  See, e.g., In the Matter of the Application of Cynthia C. Reinhart, CPA, SEC Rel. No. 85964 at 19 n.38 (May 29, 2019).   [29]   See AS 4101, Responsibilities Regarding Filings Under Federal Securities Statutes.   [30]   Compare AS 2415.02 (“date of the financial statements being audited”) to ASC 205-40-50-1 (“date that the financial statements are issued”).   [31]   ASU 2014-15, ¶ BC28.   [32]   AS 2415.02 (emphasis added).   [33]   See generally SEC Rel. No. 85964.   [34]   See id. at 8 (use of subsequent balance-sheet date for analysis); 8-11 (evidence concerning liquidity arising during subsequent period after balance-sheet date).   [35]   See, e.g., John H. Eickemeyer, “The Concerns with Going Concern,” The CPA Journal (Jan. 2016). Gibson Dunn’s lawyers are available to assist with any questions you may have regarding developments related to the COVID-19 pandemic. For additional information, please contact any member of the firm’s Securities Regulation and Corporate Governance or Business Restructuring and Reorganization practice groups, the Gibson Dunn lawyer with whom you usually work, or the following authors: Authors: Brian Lane, Michael Scanlon, Michael Rosenthal, Jeffrey Krause, David Ware, and David Korvin © 2020 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
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May 27, 2020

Gaps in the EPA’s COVID-19 Temporary Enforcement Policy: What Regulated Entities Should Consider as Compliance Issues Arise Due to the Pandemic

Click for PDF Since the U.S Environmental Protection Agency (EPA) issued its “Temporary COVID-19 Enforcement Policy” (“temporary enforcement policy”) on March 26th,[1] many regulated entities have successfully obtained extensions of consent decrees and other deadlines.[2]  While federal and state enforcement discretion is welcome during this uncertain time, regulated entities should nonetheless proceed with some caution and not rely exclusively on the EPA’s temporary enforcement policy.  Indeed, some state regulators and many environmental organizations have expressed their displeasure with the temporary enforcement policy.  For example after the EPA issued its guidance, fifteen states’ attorney generals signed a letter calling on the EPA to rescind its temporary enforcement policy and vowed to “enforce [their] state[’s] environmental laws in a reasonable manner, and. . . hold regulated entities accountable under critical federal environmental laws if EPA will not.”[3] And, earlier this month attorney generals from the states of New York, California, Illinois, Maryland, Michigan, Minnesota, Oregon, Vermont, and Virginia sued the EPA for its “broad, open-ended [COVID-19 enforcement] policy” the states claim “gives regulated parties free rein to self-determine when compliance with federal laws is not practical because of COVID-19.”[4] Likewise, a “coalition of environmental justice, public health, and public interest organizations” filed suit against the EPA and two Administrators in April condemning the temporary enforcement policy and seeking an order demanding that the EPA respond to the coalition’s petition for emergency rule-making.[5] This client alert explores aspects of enforcement liability unaffected by the EPA’s temporary enforcement policy that regulated entities should consider as they pursue relief as compliance issues arise as the result of pandemic-related issues. Gaps in the EPA’s Temporary Enforcement Policy Contrary to public perception, the EPA’s temporary enforcement policy does not eliminate or waive environmental requirements.[6]  Rather, regulated entities are still “expected to make every effort to comply with all applicable requirements,” and the EPA “will not seek penalties for noncompliance with routine monitoring and reporting requirements if, on a case-by-case basis, the EPA agrees that such noncompliance was caused by the COVID-19 public health emergency.”[7]  The EPA developed the temporary enforcement policy to enable it to “prioritize its resources to respond to acute risks and imminent threats, rather than mak[e] up front case-by-case determinations regarding routine monitoring and reporting” as regulators and regulated entities deal with the unprecedented situation where compliance and/or monitoring may be difficult, if not impossible, because employees cannot travel, are subject to stay-at-home orders, or are sick.[8] Generally, under the temporary enforcement policy, the EPA does not anticipate seeking “penalties for violations of routine compliance monitoring, integrity testing, sampling, laboratory analysis, training and reporting or certification obligations” where COVID-19 caused the noncompliance and the regulated entity provides supporting documentation upon request.[9]  That said, the EPA makes clear that nothing in the policy “relieves any entity from the responsibility to prevent, respond to, or report accidental releases of oil, hazardous substances, hazardous chemicals, hazardous waste, and other pollutants, as required by federal law” nor should the policy be interpreted to provide enforcement discretion in the event of such a release.[10]  Moreover, the enforcement discretion described in the temporary policy does not apply to criminal violations or probation conditions in criminal sentences, activities that are carried out under Superfund and RCRA corrective action enforcement instruments, or imports.[11] Thus, while the temporary enforcement policy shows the federal government may be willing to forgive some forms of environmental noncompliance due to COVID-19, the EPA’s enforcement discretion is not absolute.  Moreover, the temporary enforcement policy does not absolve regulated entities of liability arising from private citizen suits and state enforcement actions despite the EPA’s noncompliance carve-out.  Indeed, the temporary enforcement policy acknowledges as much, noting that “[a]uthorized states or tribes may take a different approach under their own authorities.”[12]  Therefore, regulated entities facing potential noncompliance as a result of the pandemic must also consider enforcement risks they may face from other actors, notwithstanding the EPA’s temporary enforcement policy. Risk of Citizen Suits In the environmental context, citizen suits are private civil actions brought by individuals against regulated entities (and often the EPA) for failing to comply with (or in the EPA’s case enforce) certain regulations.  Numerous federal environmental statutes permit enforcement via citizen suits, including the Clean Water Act, the Clean Air Act, RCRA,[13] and CERCLA.  For example, the Clean Water Act provides that “any citizen may commence a civil action on his own behalf…against any person…who is alleged to be in violation of (A) an effluent standard or limitation under this chapter or (B) an order issued by the Administrator or a state with respect to such a standard or limitation.”[14]  Similarly, the Clean Air Act allows any person to “commence a civil action on his own behalf…against any person…who is alleged to have violated (if there is evidence that the violation has been repeated) or to be in violation of (A) an emission standard or limitation under this chapter or (B) an order issued by the Administrator or a State with respect to such a standard or limitation” and “against any person who proposes to construct or constructs any new or modified major emitting facility without a permit…or who is alleged to have violated (if there is evidence that the alleged violation has been repeated) or to be in violation of any condition of such permit.”[15]  Because the EPA’s temporary enforcement policy only governs the EPA’s enforcement discretion and does not supplant or replace any existing environmental statutes, citizen suit provisions in federal environmental statutes remain unaffected and therefore, enforcement liability for COVID-19-related noncompliance via citizen suits is still a threat. One question, however, is whether permitting citizen suits for noncompliance resulting from a global pandemic accords with congressional intent behind citizen suits.  The legislative history of the Clean Air Act, the first federal environmental statute to authorize citizen suits, indicates that Congress authorized citizen suits as an enforcement mechanism, in part because Congress recognized that the government’s limited resources could hinder adequate enforcement and private enforcement could spur the government to act when it otherwise would not.[16] Under current circumstances, however, it would seem that the EPA’s enforcement capabilities are not limited by resource constraints but rather public health guidelines.  And, facilities and regulators are experiencing difficulty complying and monitoring compliance due to unprecedented circumstances where employees and contractors are ill and/or subject to stay-at-home orders and social distancing guidelines. Additionally, there may be procedural barriers that limit the viability of citizen suits challenging regulated entities’ COVID-19 related noncompliance, especially if such noncompliance is limited in time and scope.  First, some citizen suit provisions, like those in the Clean Air Act and Clean Water Act, mandate that private litigants cannot bring a citizen suit until 60 days after they have given notice to “any alleged violator.”[17]  Second, some statutes limit the ability for plaintiffs to bring citizen suits when the conduct complained of has ceased.  For example, the Clean Water Act does not allow citizen suits based on wholly past conduct[18] and the Clean Air Act only permits citizen suits for past violations if they are alleged to be “repeated.”[19]  These requirements may make it difficult to maintain a citizen suit action based on noncompliance caused by COVID-19 that may be limited to a “one-off” violation that ends as soon as workers and contractors are healthy and/or stay-at-home orders are lifted. Relatedly, regulated entities may also attempt to dismiss citizen suits for COVID-19 related noncompliance on grounds that a citizen suit has since become moot.  Admittedly, mootness in the environmental law context has been made more difficult after the Supreme Court’s decision in Friends of the Earth, Inc. v. Laidlaw Environmental Servs., Inc., in which the Court held that “[a] defendant’s voluntary cessation of allegedly unlawful conduct ordinarily does not suffice to moot a case.”[20]  However, a case may nonetheless become moot where “subsequent events made it absolutely clear that the allegedly wrongful behavior could not reasonably be expected to recur.”[21]  Thus, while regulated entities may bear a “heavy burden” to satisfy the mootness standard, noncompliance caused by a global pandemic and stay-at-home orders could be sufficiently abnormal such that a court would conclude that a regulated entity’s voluntary cessation of noncompliant conduct (i.e. becoming re-complaint upon the termination of stay-at-home orders) would not “reasonably be expected to recur.” Risk of State Enforcement Actions Because the EPA and state environmental authorities retain power over public health and the environment and many environmental statutes provide for dual enforcement by the federal government and state authorities, the EPA’s temporary enforcement policy cannot and does not supplant individual states’ authority to police environmental noncompliance caused by COVID-19.[22]  As such, regulated entities remain subject to state enforcement actions despite the EPA’s temporary policy.  Regulated entities should, therefore, be aware of their states’ position on noncompliance stemming from the COVID-19 pandemic and determine to what extent, if any, their state’s position departs from that of the EPA. States environmental agencies have had various reactions to the EPA’s temporary enforcement policy.  Many state environmental agencies took a similar stance to the EPA’s position and reaffirmed their commitment to protect the environment and public health, while simultaneously recognizing that the COVID-19 pandemic may present compliance challenges for regulated entities.  For example, in a letter to the public, the chairman of the Texas Commission on Environmental Quality (TCEQ) noted that it had not relaxed “any limits on air emissions or discharges to water” and had not “relaxed the requirement to report emissions or discharges that exceed these limits.”[23]  The chairman reiterated that despite the COVID-19 pandemic, TCEQ remains “fully engaged in its mission to protect public health and the environment.”[24]  However, like the EPA, TCEQ stated that it would exercise enforcement discretion in certain cases as regulated entities navigate the pandemic: “TCEQ’s Executive Director has determined that it may be inappropriate to pursue enforcement for violations that were unavoidable due to the pandemic or where compliance would create an unreasonable risk of transmitting COVID-19 or otherwise impede an appropriate response to the pandemic. Accordingly, TCEQ will consider exercising its discretion to not bring enforcement actions for such violations on a case-by-case basis. This is not a suspension of rules. . . And this is certainly not an exemption from agency rules . . . Importantly, TCEQ is not offering enforcement forbearance where an entity fails to report its noncompliance.”[25] Still, other states, including those that have a high number of COVID-19 cases like California and Michigan, adopted a similar tone—recognizing that regulated entities may need additional time or assistance in order to meet their compliance obligations.  For example, on April 15, CalEPA issued a statement on its expectations for regulatory compliance during the COVID-19 pandemic.  The agency reaffirmed its commitment to safeguarding “public health, safety, and the environment during the COVID-19 pandemic” and acknowledged that “controlling pollution in communities with high rates of respiratory disease and multiple environmental burdens” remained a priority “especially given recent studies that suggest a correlation between these factors and COVID-19 susceptibility.”[26]  Nonetheless, CalEPA also recognized that “some regulated entities may need additional compliance assistance as a result of the COVID-19 pandemic.”[27]  CalEPA stated that some extension of deadlines “may be warranted under clearly articulated circumstances,” but noted that regulated entities must affirmatively contact CalEPA “before falling out of compliance.”[28] Michigan’s environmental authority, the Michigan Department of Environment, Great Lakes and Energy (EGLE), too, affirmed its commitment to protecting “public health and the environment” and stated that it “expect[s] all businesses to adhere to environmental regulations and permit requirements.”[29]  Much like CalEPA’s response, the EGLE also indicated that it would make exceptions for entities who cannot safely meet certain environmental obligations while still adhering to Michigan’s social distancing guidelines: “In cases where a regulated entity believes it cannot meet certain obligations without endangering the health and welfare of employees or others as a result of complications from the COVID-19 pandemic, the agency will make case-by-case determinations on temporary alterations to reporting or compliance requirements. Requests for temporary deviation from regulations and permit requirements may be made. . .[and] [t]hey will be asked to answer a series of questions, providing detailed information and specific rationale on the necessity of altering their obligation, after which a determination will be made.”[30] Based on the public statements, it seems that states may be willing to work with regulated entities who risk noncompliance caused by COVID-19 so long as such entities communicate their risks with state authorities and document the ways in which their noncompliance was caused by COVID-19.  However, some states are exercising less enforcement discretion than others, as CalEPA has not indicated that it will not seek penalties for noncompliance but may grant specific time-delimited remedies. In addition, regulated entities should check their state’s existing laws on self-reporting and auditing as they may protect against liability resulting from COVID-19 related noncompliance so long as entities self-report.  For example, Texas provides immunity for certain violations uncovered through voluntary audits under the Texas Environmental Health, and Safety Audit Privilege Act.[31] Conclusion and Best Practices While regulated entities may view the EPA’s temporary enforcement policy as a welcome acknowledgement that the COVID-19 pandemic has made environmental compliance and monitoring difficult, if not impossible, such entities should also consider the liability risks that exist despite the EPA’s policy—like citizen suits and state enforcement actions.  In accordance with the temporary enforcement policy, regulated entities should at a minimum “document decisions made to prevent or mitigate noncompliance and demonstrate how the noncompliance was caused by the COVID-19 pandemic.”[32]  Any evidence showing that the noncompliance was or will be limited in duration or scope may also be helpful.  To further mitigate liability for noncompliance caused by COVID-19, it may be prudent for regulated entities to inform the EPA and state environmental agencies of their potential noncompliance before it occurs and follow their recommended guidance. In short, as regulated entities and regulators seek to navigate this public health crisis, facilities that find themselves risking noncompliance due to COVID-19 should take comfort in the EPA’s willingness to work with them as articulated in its temporary enforcement policy.  However, entities should beware of other liability risks that remain unaffected by the EPA’s policy.  While entities should always seek to achieve and maintain compliance with environmental regulations, now more than ever, it is imperative that they communicate the unique challenges they face to the EPA and its state corollaries early and often. ____________________    [1]   See “COVID-19 Implications for EPA’s Enforcement and Compliance Assurance Program,” Environmental Protection Agency (available at https://www.epa.gov/sites/production/files/2020-03/documents/oecamemooncovid19implications.pdf).    [2]   See, e.g., “TCEQ COVID-19 Enforcement Discretion Requests,” Texas Commission on Environmental Quality, (available at https://www.tceq.texas.gov/downloads/response/covid-19/enforcement-discretion-list-042420.xlsx/view).    [3]   See Letter from Attorneys General of New York, Illinois, Iowa, Maryland, Massachusetts, Michigan, Minnesota, Oregon, Pennsylvania, Rhode Island, Vermont, Virginia, Washington and Wisconsin to Administrator Andrew Wheeler, April 15, 2020, (available at https://www.attorneygeneral.gov/wp-content/uploads/2020/04/2020-04-16-Final-AGs-letter-on-EPA-enforcement-discretion-policy.pdf); see also Letter from California Attorney General Xavier Becerra to Assistant Administrator Susan Parker Bodine, April 9, 2020, (available at https://oag.ca.gov/system/files/attachments/press-docs/CA%20Attorney%20General%20Letter%20re%20EPA%20COVID-19%20Policy%204.9.2020.pdf).    [4]   State of New York, et al., v. U.S. Env’tal Protection Agency, et al., No. 1:20-cv-03714, Dkt. 1 (S.D.N.Y. May 13, 2020).    [5]   Natural Res. Def. Council, et al., v. Bodine, et al., No. 1:20-cv-03058, Dkt. 1 (S.D.N.Y. Apr. 16, 2020).    [6]   See “Frequent Questions About the Temporary COVID-19 Enforcement Policy,” (available at https://www.epa.gov/enforcement/frequent-questions-about-temporary-covid-19-enforcement-policy).    [7]   Id.    [8]   Id.    [9]   See  COVID-19 Implications for EPA’s Enforcement and Compliance Assurance Program. [10]   See id. [11]   See id. [12]   See COVID-19 Implications for EPA’s Enforcement and Compliance Assurance Program; see also Frequent Questions About the Temporary COVID-19 Enforcement Policy (“The Policy acknowledges the important role played by our state, tribal and territorial partners, and specifically notes states or tribes may take a different approach under their own authorities.  Some states have already issued their own guidance.”). [13]   Note, however, that activities carried out pursuant to a RCRA corrective action are not subject to the enforcement discretion provided for in the temporary enforcement policy.  See COVID-19 Implications for EPA’s Enforcement and Compliance Assurance Program. [14]   33 U.S.C.A. § 1365(a)(1). [15]   42 U.S.C.A. § 7604(a)(1) and (3). [16]   See generally Natural Resources Defense Council v. Train, 510 F.2d 692 (D.C. Cir. 1974) (quoting the legislative history of the Clean Air Act Amendments of 1970). [17]   See 33 U.S.C.A. § 1365(b)(1); see also 42 U.S.C.A. § 7604(b)(1).  Note, however, that citizen suits brought under § 7604(a)(3) of the Clean Air Act, which governs issues with permits, are not subject to the 60 day notice requirement. [18]   Gwaltney of Smithfield, Ltd. v. Chesapeake Bay Found., Inc., 484 U.S. 49, 54–62 (1987), superseded by statute on other grounds as recognized by Env’t Tex. Citizen Lobby, Inc. v. ExxonMobil Corp., 824 F.3d 507, 529 n.18 (5th Cir. 2016). [19]   See 42 U.S.C.A. § 7604(a)(1) and (3). [20]   528 U.S. 167, 174 (2000). [21]   Id. at 189 (quoting U.S. v. Concentrated Phosphate Export Ass’n., 393 U.S. 199, 20003 (1968)). [22]   See COVID-19 Implications for EPA’s Enforcement and Compliance Assurance Program. [23]   “TCEQ message to concerned citizens, public advocates, and members of the regulated community,” Texas Comm’n on Environmental Quality, April 6, 2020 (available at https://www.tceq.texas.gov/news/tceqnews/features/tceq-message-concerning-covid-19-response). [24]   Id. [25]   Id. [26]   “CalEPA Issues Statement on Compliance with Regulatory Requirements During the COVID-19 Emergency,” California Environmental Protection Agency, April 15, 2020, (available at https://calepa.ca.gov/2020/04/15/calepa-statement-on-compliance-with-regulatory-requirements-during-the-covid-19-emergency/). [27]   Id. [28]   Id. [29]   “Is EGLE still enforcing pollution laws and the conditions of permits issued to entities that release pollutants?”, Michigan Dept. of Env’t, Great Lakes, and Energy, (available at https://www.michigan.gov/egle/0,9429,7-135-99239-525079--,00.html). [30]   “Are you making exceptions in cases where the COVID-19 crisis makes it dangerous for workers at regulated companies to adhere to their regulatory obligations?” Michigan Dept. of Env’t, Great Lakes, and Energy, (available at https://www.michigan.gov/egle/0,9429,7-135-99239-525084--,00.html). [31]   See TX HEALTH & S § 1101.151. [32]   “EPA Announces Enforcement Discretion Policy for COVID-19 Pandemic,” March 26, 2020 (available at https://www.epa.gov/newsreleases/epa-announces-enforcement-discretion-policy-covid-19-pandemic). 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, any member of the firm’s Environmental Litigation and Mass Tort practice group, or the authors: Michael K. Murphy – Washington, D.C. (+1 202-955-8238, mmurphy@gibsondunn.com) Abbey Hudson – Los Angeles (+1 213-229-7954, ahudson@gibsondunn.com) Dione Garlick – Los Angeles (+1 213-229-7205, dgarlick@gibsondunn.com) Nicole R. Matthews – Los Angeles (+1 213-229-7649, nmatthews@gibsondunn.com) © 2020 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
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May 27, 2020

German Foreign Investment Control Tightens Further

Click for PDF On May 20, 2020, the German government has adopted an amendment (the “Amendment”) to the German Foreign Trade and Payments Ordinance (Außenwirtschaftsverordnung or “AWV”) further increasing the scrutiny of foreign direct investments (the “FDIs”). The Amendment focuses on the health sector, addressing apparent pitfalls exposed by the COVID-19 crisis. The tightening of FDI screening rules was also encouraged by the European Commission which called upon the EU member states to take protective measures in response to the COVID-19 outbreak, in particular “to be vigilant and use all tools available at Union and national level to avoid that the current crisis leads to a loss of critical assets and technology” (see Communication from the Commission of March 13, 2020). Further, the Amendment precedes a contemplated amendment of the German Foreign Trade and Payments Act (Außenwirtschaftsgesetz or “AWG”) which is currently discussed in the German parliament and expected to be approved – possibly in a slightly revised version – within the next few weeks (the “Draft AWG Amendment”). While the AWV codifies the detailed procedural rules of the German review process, the AWG provides the overall framework of the FDI screening mechanism. The Draft AWG Amendment would further tighten the rules of German foreign investment control and align the German screening mechanism with the EU Screening Regulation, which will apply from October 11, 2020 onward. In general, the German Federal Ministry for Economic Affairs and Energy (the “German Ministry”) has the competence to review and prohibit or restrict investments in domestic companies by a foreign investor on the grounds of public order or security (cross-sector review), or to ensure the protection of essential security interests of the Federal Republic of Germany (sector-specific review). “Sector-specific reviews”, which cover the defense industry and certain parts of the IT security industry, apply to all (EU and non-EU) foreign investors while “cross-sector reviews” (covering all other industry sectors) only apply to non-EU/non-EFTA foreign investors. The general threshold for screening is the direct or indirect acquisition by a foreign investor of at least 25% of the voting rights in a German company. This threshold is lowered to 10% of the voting rights for FDIs that fall under sector-specific review or fit one of the select industry categories listed as part of the cross-sector review (i.e., critical infrastructure etc.); all FDIs falling in either of these two buckets – sector-specific or listed category of cross-sector – need to be notified to the German Ministry. With the Amendment expanding the list of categories of cross-sector review, more FDIs will become notifiable and subject to screening at already 10% of the voting rights. Key Amendments to the AWV Aside from heightened scrutiny in the health-care sector, the Amendment introduces investor-related screening factors as set out in Regulation (EU) 2019/452 of March 19, 2019 establishing a framework for screening of FDIs into the EU (the “EU Screening Regulation”) and provides for minor clarifications. The Amendment provides for the following key changes to the AWV: Catalog of Select Industries Subject to Cross-Sector Review. The Amendment provides for five new categories to be added to the catalog of cross-sector review.Health-Care Related Additions Development or production of personal protective equipment; Development, production, or marketing of material pharmaceuticals (wesentliche Arzneimittel), including holders of respective statutory permits; Development or production of medical products designed for diagnosis, prevention, monitoring, prediction, prognosis, treatment or easement of life-threatening and highly contagious infectious diseases; Development or production of in-vitro-diagnostics used in connection with life-threatening and highly contagious infectious diseases. In individual cases, these new categories – except for the development/production of personal protective equipment – may overlap with the category of critical infrastructures. As per the German Ministry, it does not matter, however, if the security-relevant nature of the target company can be derived from one or two categories as the legal consequences do not vary. Other Addition Providing services which ensure the interference-free operation and functioning of governmental communication infrastructure operated by the Federal Agency for Public Safety Digital Radio (Bundesanstalt für den Digitalfunk der Behörden und Organisationen mit Sicherheitsaufgaben). Companies falling in this category for instance provide facility management services, maintenance and fault elimination (Entstörung) services, install technical equipment at office locations of the Federal Agency for Public Safety Digital Radio or provide security-related consulting services to the latter. Applicability to Share and Asset Deals. The Amendment codifies that German FDI control is not limited to the acquisition of shares but equally applies to asset deals. Notification Modalities. The Amendment clarifies that FDIs triggering a notification obligation are to be notified immediately after signing of the acquisition agreement. The notification generally has to be submitted by the direct acquirer (even if the acquisition vehicle itself is not “foreign”) but may also be made by the indirect acquirer instead. Investor-Related Screening Factors. In line with the EU Screening Regulation, the Amendment formally introduces screening factors that focus on the background and activities of the individual investor. According to the German Ministry, these changes are of clarifying nature only, as investor-related factors have previously been considered as well. Pursuant to the Amendment, the German Ministry may now take into account whether the foreign investor is directly or indirectly controlled by the government, including state bodies or armed forces, of a third country, including through ownership structure or more than insignificant funding, has already been involved in activities affecting the public order or security of the Federal Republic of Germany or of a fellow EU member state, or whether there is a serious risk that the foreign investor, or persons acting for it, were or are engaged in activities that, in Germany, would be punishable as a certain criminal or administrative offence, such as terrorist financing, money laundering, fraud, corruption, or violations of the foreign trade or war weapon control rules. Contemplated Changes to the German Foreign Trade and Payments Act To some extent, the Draft AWG Amendment introduces changes that were necessary to comply with the EU Screening Regulation which establishes a common framework for screening and an EU-coordinated cooperation among EU member states through the exchange of information and the possibility to issue comments (or, in case of the European Commission, an opinion) to fellow EU member states on a particular FDI (see Client Alert of March 5, 2019). The Draft AWG Amendment, which may still be altered in the course of the legislative procedure, proposes the following key amendments to the AWG: Expanding the Grounds for Screening. In line with the EU Screening Regulation, grounds for screening shall be expanded to include public order or security of a fellow EU member state as well as effects on projects or programs of EU interest. In this context, we note that the European Commission, in response to the COVID-19 crisis, issued guidance concerning FDI from third countries stating that acquisitions of healthcare-related assets would have an impact on the European Union as a whole (see Communication from the Commission of March 25, 2020). Tightening the Standards. In line with the EU Screening Regulation, the standards under which an FDI is prohibited or restrictive measures are imposed will be changed from whether the FDI constitutes an “actual and duly serious threat” (tatsächliche und hinreichend schwere Gefährdung) to whether the FDI is “likely to affect” (voraussichtliche Beeinträchtigung) the public order or security of the Federal Republic of Germany, of a fellow EU member state, or projects or programs of EU interest. This would give the German Ministry more discretion and room to maneuver as it could prohibit a transaction in order to prevent an impairment that has not yet materialized but that is likely to occur as a result of the contemplated FDI. Expanding Sector-Specific Screening. Currently, FDI in companies producing or developing war weapons, armaments or related IT products certified by the German Federal Office for Information Security (Bundesamt für Sicherheit in der Informationstechnik) are subject to sector-specific review if at least 10% of the voting rights are acquired. Pursuant to the Draft AWG Amendment, not only the production and development of such goods would qualify for a sector-specific control, but also expressly the modification or use of such goods. The same shall apply if the respective company no longer produces, develops, modifies or uses but still has the relevant knowledge (e.g., because of knowledge of individual employees) or otherwise has access to the security-sensitive technology (e.g., through documents or storage media, if the respective employee already left). Effects on Consummating Transactions. Currently, FDIs subject to cross-sector review (i.e., all industry sectors except for defense/certain IT security) de facto may be consummated at any time – even during an ongoing screening process. The underlying acquisition agreement is deemed valid from the beginning and will only become invalid if the German Ministry prohibits the FDI subsequently (condition subsequent), in which case the transaction must be rewound. On the contrary, transactions subject to sector-specific review (i.e., the defense industry and certain parts of the IT security industry) may only be consummated upon conclusion of the screening process (condition precedent). In the past, investors have closed transactions falling under cross-sector review while the review process was still ongoing and thereby confronted the German Ministry with accomplished facts. Therefore, the Amendment now proposes that transactions falling under cross-sector review that are notifiable may only be consummated upon conclusion of the screening process (condition precedent). We expect this to have a tangible impact on the transaction practice given the broad range of notifiable FDIs in the cross-sector category, which would be affected by this change. Foreign investors will need to carefully assess if the target company operates in one of the listed industry categories. From a drafting perspective, acquisition agreements regarding notifiable FDIs should include (A) a closing condition that the FDI is (deemed) cleared by the German Ministry, and (B) a mechanism allowing for the amendment or termination of the acquisition agreement in case the German Ministry imposes (comprehensive) restrictive measures. Penalizing the Disclosure of Security-Relevant Information and Certain Consummation Actions Pending Screening. The Draft AWG Amendment provides for punishment of certain willful infringements of the AWG – and attempted infringements – by way of imprisonment of up to five years or fine or, in case of negligence, with a fine of up to EUR 500,000. The following actions shall be penalized: Enabling the investor to, directly or indirectly, exercise voting rights; Granting the investor dividends or any economic equivalent; Providing or otherwise disclosing to the investor information on the German target company with respect to company objects and divisions that are subject to screening on grounds of essential security interests of the Federal Republic of Germany, or of particular importance when screening for effects on public order and security of the Federal Republic of Germany, or that have been declared as ‘significant’ by the German Ministry; Non-compliance with enforceable restrictive measures (vollziehbare Anordnungen) imposed by the German Ministry. Currently, only the non-compliance with enforceable restrictive measures is punishable with a fine of up to EUR 500,000. The introduction of criminal liability will lead to even more focus on whether or not the transaction requires FDI clearing. The seller de facto will be forced to include the clearing by the German Ministry as a closing condition to avoid exposure to criminal liability. According to the explanatory notes (Gesetzesbegründung) to the Draft AWG Amendment, the prohibition to disclose security-sensitive information as described above would usually not apply to purely or other company-related commercial information that is exchanged in the course of a transaction in order to allow the investor to conduct a sound evaluation of the economic opportunities and risks of the FDI. Nonetheless, the seller would need to be cautious when preparing the due diligence process, in particular when populating the virtual data room. Typically, security-sensitive information as described above would not be shared with potential buyers prior to closing of the transaction anyway. Should the need arise, however, the use of a red data room and special disclosure and confidentiality obligations based on a clean team agreement may be required. More Effective Monitoring of Compliance with Measures. Investors and target companies are to expect more monitoring activity by the German Ministry as the Draft AWG Amendment, once enacted, will provide the German Ministry with a right of information as well as a right to carry out examinations (including access to stored data, respective data processing systems, and business premises, in each case also by use of third-party representatives (Beauftragte)) in order to better monitor the investor’s and/or target company’s compliance with contractually agreed or imposed measures. Imposing Restrictive Measures without Consent of the German Government. Currently, restrictive measures regarding FDIs subject to cross-sector review can only be imposed with the consent of the German government. The Draft AWG Amendment proposes that restrictive measures may be imposed in agreement with and/or consultation of certain federal ministries instead. For the sake of clarity, the German Ministry would still require the consent of the German government if it wanted to prohibit an FDI that is subject to cross-sector review. This would not change. Further Changes to the AWV to Follow Further amendments to the AWV are scheduled to follow over the summer. These further changes have been announced already in 2019 but were delayed due to recent events. Initially, i.e. before the COVID-19 crisis had reached Europe, the German Ministry had contemplated to expand the catalog of select industries within the cross-sector review to include, inter alia, the following critical technologies: artificial intelligence, robotics, semiconductors, biotechnology and quantum technology. Also, the procedure and time frames of German FDI control have arguably yet to be adjusted to ensure that the new EU consultation process is completed before the German Ministry has to render its screening decision. Moreover, the (soon to be adopted) changes to the AWG will need to be implemented in the AWV.   In conclusion, while the German Ministry emphasizes that Germany welcomes foreign direct investments, the trend towards more protectionism continues, greatly intensified by the ramifications of the COVID-19 crisis. For non-EU and non-EFTA investors seeking to invest in German companies, a potential review pursuant to German FDI control will become increasingly important. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding the issues discussed in this update. For further information, please feel free to contact the Gibson Dunn lawyer with whom you usually work, any member of the team in Frankfurt or Munich, or the following authors: Markus Nauheim - Munich (+49 89 189 33 122, mnauheim@gibsondunn.com) Wilhelm Reinhardt - Frankfurt (+49 69 247 411 502, wreinhardt@gibsondunn.com) Stefanie Zirkel - Frankfurt (+49 69 247 411 513, szirkel@gibsondunn.com) © 2020 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
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