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Client Alert

December 11, 2019

California Legislation Increases Antitrust Scrutiny of Patent Settlements between Branded and Generic Pharmaceutical Manufacturers

Click for PDF On October 7, 2019, California enacted Assembly Bill 824 (AB 824)[1] in an effort to increase antitrust scrutiny of patent settlement agreements between branded and generic pharmaceutical manufacturers. The focus of the legislation is on settlements of patent infringement litigation brought under the Hatch-Waxman Act[2] that include a so-called “reverse payment,” i.e., where the generic manufacturer receives a cash payment or some other form of consideration from the branded manufacturer. AB 824 also, however, expressly covers settlements of patent litigation brought under the Biologics Price Competition and Innovation Act (BPCIA). The California legislation threatens to greatly complicate the settlement of these actions and we recommend that any branded or generic manufacturer involved in such matters carefully consider and take account of such legislation. Increased Burdens on Defense. AB 824 seeks to make it more difficult for parties to defend patent settlements with “reverse payments” by shifting the burdens of proof. Under the U.S. Supreme Court’s opinion in FTC v. Actavis, the plaintiff bears the burden of demonstrating that the settlement contains a “large and unjustified” reverse payment and an overall “anticompetitive effect.”[3] Only upon such a showing would the burden shift to the settling parties to demonstrate the agreement’s pro-competitive merit. Under AB 824, however, once an antitrust plaintiff or enforcement body shows that the generic manufacturer agrees to limit or delay its market entry and receives “anything of value” in the patent settlement, anticompetitive effects are presumed and the burden is shifted to the settling parties to show the settlement agreement in question is procompetitive.[4] The settling parties may seek to rebut the presumption of anticompetitive effects by demonstrating that the procompetitive effects of the settlement outweigh any anticompetitive effects, or that the value received by the generic manufacturer was “fair and reasonable compensation solely for other goods and services” that the generic has agreed to provide the branded manufacturer.[5] The legislation also contains several other presumptions that are designed to make it more difficult for the settling parties to argue that their agreement was innocuous and/or had no material effect on competition. ”Anything of Value.” AB 824 defines “anything of value” broadly to include exclusive licenses and so-called “no authorized generic” provisions wherein the branded manufacturer agrees not to market or license an authorized generic during a negotiated period of time.[6] But it expressly excludes several categories of payments or agreements including licenses to market a generic version of a drug before expiration of a listed patent, acceleration clauses based on the NDA holder marketing a different dosage strength or form, waiver of damages accrued from an at-risk launch of the generic drug, and, “reasonable future litigation expenses” that have been previously documented.[7] These exceptions could prove useful in litigation and parties negotiating such settlements will likely want to carefully consider whether their proposed settlements fit within these apparent safe harbors Civil Penalties and Potential for Individual Liability. AB 824 purports to increase parties’ existing exposure under California antitrust and unfair competition law by providing for civil penalties of $20 million or more. Of perhaps greatest concern is that AB 824 could potentially be read to permit those civil penalties to be applied to individuals at the involved companies who “participate” or “assist” in its violation.[8] Retroactivity. A question might be raised as to whether AB 824 could be applied to settlement agreements reached before its enactment. Statutes (especially those that include penalties), are generally presumed to be prospective only, and AB 824 has an effective date of January 1, 2020. There is therefore good reason to believe that AB 824 should not be interpreted to apply retroactively, although the statute is silent on this point. Constitutional? The legislation’s broad sweep—and its departure from the standards set forth by the Supreme Court under federal law—raises serious questions as to whether the statute violates the U.S. Constitution. Although the legislation has provisions that purport to limit its application to agreements within California’s jurisdictional reach, in practice the standards and penalties it provides are likely to effectively regulate the content of almost any patent settlement in the U.S. between a branded and generic manufacturer given that such settlements typically apply nationally and cannot practically be limited to a particular section of the country.   For this reason, the legislation appears to be vulnerable to a challenge based on the Dormant Commerce Clause of the U.S. Constitution. In a recent development, a lawsuit was filed by a consortium of generic drug manufacturers challenging AB 824 on that and a variety of other constitutional grounds.[9] ________________________    [1]   To be codified at Cal. Health & Safety Code § 134000.    [2]   Drug Price Competition and Patent Term Restoration Act (codified at 21 U.S.C. §§ 355 & 360cc).    [3]   See FTC v. Actavis, Inc., 570 U.S. 136, 158 (2013); see also In re Cipro Cases I & II, 61 Cal. 4th 116, 348 P. 3d 845 (Cal. 2015).    [4]   AB 824 § 134002(a)(1)(A) and (B).    [5]   Id. at § 134002(a)(3)(A).    [6]   Id.    [7]   AB 824 § 134002(a)(2)(A)–(F). “Reasonable future litigation expenses” must be documented in budgets by the Abbreviated New Drug Application (ANDA) holder at least six months prior to the settlement, and cannot exceed the greater of $7,500,000 or 5% of the ANDA holder’s projected revenue for the first three years of sales of its generic, with documentation predating the settlement by at least 12 months. Id. at § 134002 (a)(2)(C)(ii)(I-II).    [8]   Id. at § 134002(e)(1)(A)(i) (“Each person that violates or assists in the violation of this section shall forfeit and pay to the State of California a civil penalty sufficient to deter violations of this section . . . an amount up to three times the value received by the party that is reasonably attributable to the violation of this section, or twenty million dollars ($20,000,000), whichever is greater.”) (emphasis added).    [9]   See Association for Accessible Medicines v. Becerra, No. 19-CV-2281 (E.D. Cal. Nov. 12, 2019). Gibson Dunn's lawyers are available to assist in addressing any questions you may have regarding these developments. To learn more about these issues, 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: Kristen C. Limarzi - Washington, D.C. (+1 202-887-3518, klimarzi@gibsondunn.com) Eric J. Stock - New York (+1 212-351-2301, estock@gibsondunn.com) Please also feel free to contact any of the following practice group members: Antitrust and Competition Group: Washington, D.C. D. Jarrett Arp (+1 202-955-8678, jarp@gibsondunn.com) Adam Di Vincenzo (+1 202-887-3704, adivincenzo@gibsondunn.com) Scott D. Hammond (+1 202-887-3684, shammond@gibsondunn.com) Kristen C. Limarzi (+1 202-887-3518, klimarzi@gibsondunn.com) Joshua Lipton (+1 202-955-8226, jlipton@gibsondunn.com) Richard G. Parker (+1 202-955-8503, rparker@gibsondunn.com) Cynthia Richman (+1 202-955-8234, crichman@gibsondunn.com) Jeremy Robison (+1 202-955-8518, wrobison@gibsondunn.com) Chris Wilson (+1 202-955-8520, cwilson@gibsondunn.com) New York Eric J. Stock (+1 212-351-2301, estock@gibsondunn.com) Los Angeles Daniel G. Swanson (+1 213-229-7430, dswanson@gibsondunn.com) Samuel G. Liversidge (+1 213-229-7420, sliversidge@gibsondunn.com) Jay P. Srinivasan (+1 213-229-7296, jsrinivasan@gibsondunn.com) Rod J. Stone (+1 213-229-7256, rstone@gibsondunn.com) San Francisco Rachel S. Brass (+1 415-393-8293, rbrass@gibsondunn.com) Dallas Veronica S. Lewis (+1 214-698-3320, vlewis@gibsondunn.com) Mike Raiff (+1 214-698-3350, mraiff@gibsondunn.com) Brian Robison (+1 214-698-3370, brobison@gibsondunn.com) Robert C. Walters (+1 214-698-3114, rwalters@gibsondunn.com) Brussels Peter Alexiadis (+32 2 554 7200, palexiadis@gibsondunn.com) Jens-Olrik Murach (+32 2 554 7240, jmurach@gibsondunn.com) Christian Riis-Madsen (+32 2 554 72 05, criis@gibsondunn.com) Lena Sandberg (+32 2 554 72 60, lsandberg@gibsondunn.com) David Wood (+32 2 554 7210, dwood@gibsondunn.com) Munich Michael Walther (+49 89 189 33 180, mwalther@gibsondunn.com) Kai Gesing (+49 89 189 33 180, kgesing@gibsondunn.com) London Patrick Doris (+44 20 7071 4276, pdoris@gibsondunn.com) Charles Falconer (+44 20 7071 4270, cfalconer@gibsondunn.com) Ali Nikpay (+44 20 7071 4273, anikpay@gibsondunn.com) Philip Rocher (+44 20 7071 4202, procher@gibsondunn.com) Deirdre Taylor (+44 20 7071 4274, dtaylor2@gibsondunn.com) Hong Kong Kelly Austin (+852 2214 3788, kaustin@gibsondunn.com) Sébastien Evrard (+852 2214 3798, sevrard@gibsondunn.com) © 2019 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
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December 11, 2019

Supreme Court Holds That The PTO’s Recovery Of “Expenses” Under The Patent Act Does Not Include Attorney’s Fees

Click for PDF Decided December 11, 2019 Peter v. NantKwest, Inc., No. 18-801 Today, the Supreme Court unanimously held that a provision in the Patent Act requiring the Patent and Trademark Office to recover all “expenses” from a patent applicant who challenges the denial of a patent application does not permit the recovery of attorney’s fees. Background: Section 145 of the Patent Act allows a patent applicant to challenge an adverse decision of the Patent and Trademark Office (“PTO”) in federal district court. The applicant, however, must pay the PTO “[a]ll the expenses of the proceedings” regardless whether the applicant prevails. 35 U.S.C. § 145.  NantKwest sued the PTO Director under Section 145 to challenge the denial of its patent application. After the district court granted summary judgment to the PTO and the Federal Circuit affirmed, the PTO moved for reimbursement of “expenses” under Section 145. For the first time in the 170-year history of Section 145, the PTO sought reimbursement for the pro rata salaries of its in-house attorneys and a paralegal who worked on the case. The district court declined the PTO’s request, holding that the word “expenses” in Section 145 is not clear enough to rebut the “American Rule”—the background principle that each party is responsible for its own attorney’s fees. On appeal, the Federal Circuit initially concluded that the PTO was entitled to attorney’s fees, but on rehearing en banc, affirmed the district court’s decision and denied the PTO’s fee request. Issue: Whether the Patent Act provision requiring a patent applicant to pay “[a]ll the expenses of the proceedings” incurred by the PTO in an action under 35 U.S.C. § 145 authorizes the PTO to recover the salaries of its in-house legal personnel. Court’s Holding: No. The term “expenses of the proceedings” in Section 145 does not encompass the salaries of the PTO’s in-house legal personnel because that language is not a clear enough indication of congressional intent to overcome the background American Rule presumption against fee shifting. “[T]he term ‘expenses’ alone has never been considered to authorize an award of attorney’s fees with sufficient clarity to overcome the American Rule presumption.” Justice Sotomayor, writing for the unanimous Court What It Means: The Court’s ruling means that unsuccessful challengers under Section 145 of the Patent Act should not be required to pay the attorney’s fees of PTO lawyers and legal staff, thus limiting the possible costs of litigating actions under Section 145. A statutory provision providing for the recovery of “expenses” alone generally does not authorize the recovery of attorney’s fees. The Court’s holding also likely prevents the PTO from collecting attorney’s fees from applicants challenging the denial of trademark registration under 15 U.S.C. § 1071(b)—the Lanham Act’s similarly worded analogue to Section 145. Beyond the Lanham Act, the collateral consequences of the Court’s holding are likely to be limited.  At oral argument, the PTO stated that it was aware of no other federal cost-shifting provision that uses the word “expenses” standing alone. More broadly, the Court’s opinion reaffirms that the American Rule presumption against fee shifting applies to all statutes, even those (like Section 145) that require expenses or costs to be shifted to unsuccessful litigants. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding developments at the Supreme Court.  Please feel free to contact the following practice leaders: Appellate and Constitutional Law Practice Allyson N. Ho +1 214.698.3233 aho@gibsondunn.com Mark A. Perry +1 202.887.3667 mperry@gibsondunn.com Related Practice: Intellectual Property Wayne Barsky +1 310.552.8500 wbarsky@gibsondunn.com Josh Krevitt +1 212.351.4000 jkrevitt@gibsondunn.com Mark Reiter +1 214.698.3100 mreiter@gibsondunn.com Howard S. Hogan +1 202.887.3640 hhogan@gibsondunn.com
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December 10, 2019

Brexit – Reporting of Derivatives under EMIR

Click for PDF In the event of the United Kingdom leaving the European Union without an agreed deal on 31 January 2020, UK counterparties will need to make changes to their derivatives reporting arrangements in advance of that date to ensure that they comply with the UK’s European Market Infrastructure Regulation (“EMIR”) reporting requirements immediately post-Brexit. This briefing sets out what steps UK counterparties to derivatives transactions should take now in relation to their reporting arrangements to ensure a smooth transition on and after Brexit. EMIR and much of its secondary implementation legislation takes the form of a Regulation and is therefore (before exit) directly applicable in UK law. The European Union (Withdrawal) Act 2018 provides that EU legislation that is directly applicable, such as EU EMIR, will form part of UK law on exit day and gives power to the UK government to amend the legislation so that it operates effectively post-Brexit. Consequently, post-Brexit there will be two versions of EMIR: the original EU version which will continue to apply to EU counterparties to derivatives transactions, EU central counterparties (“CCPs”) and EU trade repositories (“TRs”) (“EU EMIR”); and the UK version incorporating amendments during the onshoring process to ensure the regime continues to operate effectively post-Brexit (“UK EMIR”). UK EMIR will operate parallel to EU EMIR. Both regimes aim to increase the resilience and stability of OTC derivative markets. UK EMIR sets out the regulatory regime relating to OTC derivatives transactions, CCPs and TRs in the UK. Like EU EMIR, UK EMIR imposes a number of requirements on derivatives market participants which include, among other things: The obligation to centrally clear certain standardised OTC derivative contracts; Requirements to reduce the risk arising from non-centrally cleared derivatives contracts through risk mitigation techniques; and The obligation to report derivatives transactions to a TR. From exit day onwards, UK counterparties to derivatives contracts will need to comply with UK EMIR rather than EU EMIR (assuming that the UK leaves the EU with no transitional arrangements in place), including in relation to the reporting of its derivatives transactions. The UK Financial Conduct Authority (“FCA”) released a statement to explain the changes that will be in store for TRs operating in the UK, UK counterparties and UK CCPs and what is expected with respect to compliance.[1] The UK government has confirmed that, as far as possible, the policy approach set out in the EMIR legislation will not change after the UK has left the EU. This is unsurprising given that much of EMIR derived from commitments made at international level at the G20 in 2009. What should UK counterparties be doing in advance of Brexit? Undertake an audit of the UK EMIR validation rules that will apply to reports submitted on or after Brexit to UK TRs. The UK EMIR validation rules diverge from the EU EMIR validation rules and therefore it is likely that operational changes will be necessary to ensure your UK EMIR reports are compliant post-Brexit. To the extent that a UK counterparty is currently reporting its trades to an EU TR, ensure that the necessary operational changes are made in advance of exit day to ensure that trades can be reported to a UK TR immediately post-Brexit. This may involve entering into new arrangements with a UK TR. For UK counterparties who have engaged a third party or their counterparty to perform their reporting for them (i.e., “delegated” reporting), engage with their third party service provider or counterparty to ensure that they are making any necessary changes to ensure compliance post-Brexit. Any UK counterparties who have accepted a delegation from clients and agreed to report on their behalf, where those clients are based in the EU, reporting will need to be provided to an EU TR post-Brexit and for UK clients, reporting will need to be made to a UK TR for those clients. Ensuring that the necessary operational changes are made will be critical for all firms providing delegated reporting services. As all outstanding derivatives contracts entered into by a UK counterparty on or after 16 August 2012 must be held in a UK TR (whether registered or recognised) on exit day, UK counterparties should engage with their TRs to ensure all relevant trades are identified and to understand the porting process to their UK TR of choice by the date of exit. What happens to outstanding trades post-Brexit? All outstanding derivative trades entered into by UK counterparties on or after 16 August 2012, must be held in a UK registered, or recognised, TR by 11:00 p.m. UK time on exit day. This will require derivatives transactions of UK counterparties that remain outstanding to be ported to a UK TR in time for exit day and will require the necessary steps to ensure that new derivatives transactions will be reported to a UK TR beginning on exit day. UK counterparties would be well-advised to engage with their TRs to ensure orderly porting to their UK TR of choice by exit day and to ensure that all their relevant trades have been identified. UK counterparties should note that any updates to these trades required after Brexit will need to be made to the UK TR and not to the original EU TR. ______________________    [1]   See FCA statement on the reporting of derivatives under the UK EMIR regime in a no-deal scenario, available at https://www.fca.org.uk/news/statements/fca-statement-reporting-derivatives-under-uk-emir-regime-no-deal-scenario (7 November 2019). 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 in the firm's Financial Institutions and Derivatives practice groups, or the authors: Michelle M. Kirschner - London (+44 20 7071 4212, mkirschner@gibsondunn.com) Jeffrey L. Steiner - Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) Please also feel free to contact any of the following practice leaders and members: Europe: Patrick Doris - London (+44 20 7071 4276, pdoris@gibsondunn.com) Amy Kennedy - London (+44 20 7071 4283, akennedy@gibsondunn.com) Michelle M. Kirschner - London (+44 20 7071 4212, mkirschner@gibsondunn.com) Lena Sandberg - Brussels (+32 2 554 72 60, lsandberg@gibsondunn.com) United States: Matthew L. Biben - New York (+1 212-351-6300, mbiben@gibsondunn.com) Michael D. Bopp - Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com) Stephanie Brooker - Washington, D.C. (+1 202-887-3502, sbrooker@gibsondunn.com) Arthur S. Long - New York (+1 212-351-2426, along@gibsondunn.com) Jeffrey L. Steiner - Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) © 2019 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
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December 5, 2019

New Guidance on Internal Compliance Programs (“ICPs”) – What Regulators on Both Sides of the Atlantic Expect from International Business

Click for PDF The European Union has become more active in addressing EU common foreign and security policy (“CFSP”) objectives with the help of what it calls “restrictive measures,” i.e., EU Financial and Economic sanctions. As indicated in our recent client alert, The EU Introduces a New Sanctions Framework in Response to Cyber-Attack Threats and even more recent by introducing a framework for EU Financial Sanctions against Turkey,[1] it has also specifically started to unilaterally implement sanctions addressing EU security concerns, including issues beyond traditional areas addressed by sanctions such as “traditional” sanctions imposed due to terrorism and international relations-based grounds. We have discussed this development and respective challenges in our recent publication U.S., EU, and UN Sanctions: Navigating the Divide for International Business.[2] Furthermore, the EU Commission started to become more vocal on how it expects individuals and companies under its jurisdiction to implement those restrictive measures. A good example is the detailed guidance provided with regard to the EU Blocking Statute. As shown below, the EU Commission has moved forward now and published the EU Guidance on Internal Compliance Programmes (“ICPs”) for dual-use trade controls.[3] In the following, we shall highlight key recommendations of the EU guidance and some additional points we consider helpful. Please note that the competent authorities of EU member states might have additional requirements and expectations.[4] In some respects, these developments in the EU mirror recent developments in the United States. The U.S. Department of Commerce Bureau of Industry and Security (“BIS”) has previously published compliance guidance for the export of dual-use items that closely tracks the EU Commission’s guidance on ICPs.[5] The EU guidance also references similar advice on internal compliance programs published by the U.S. Department of State.[6] Most recently, the Department of the Treasury’s Office of Foreign Assets Control (“OFAC”), which administers U.S. sanctions, has published guidance on sanctions compliance best practices, advising companies to implement compliance programs with similar central features. For companies with an U.S. nexus, we suggest additionally reviewing these resources, as well as our recent client alert OFAC Releases Detailed Guidance on Sanctions Compliance Best Practices. 1.   EU Commission recommendations on internal compliance programs The guidance issued by the EU Commission is intended to support companies with applying a framework to identify, manage and mitigate risks associated with dual-use trade controls and to ensure compliance with the relevant EU and national law and regulations[7]. The guidance consists of seven core elements representing what the EU Commission believes should be the “cornerstones”[8] of a company’s individual ICP.[9] While it notes that there is no one-size-fits-all approach, it also notes that “A company’s approach to compliance that includes policies and internal procedures for, at least, all the core elements could be expected to be in line with the EU ICP guidance for dual-use trade controls.”[10] While the focus of the guidance is on managing dual-use trade[11] control impact and mitigating associated risks[12], we believe it also sheds a light on general expectations the EU Commission has with respect to internal compliance programs regarding sanctions and export controls. 1.1   Risk assessment Prerequisite for the installation of an ICP is an assessment of the company’s business activities and their related risk of violating EU export controls, specifically the dual-use regulations. Rather than identifying every single exposure to EU regulation, this risk assessment serves as a basis to design an ICP tailor-made for the company.[13] Furthermore, we suggest that in case the risk profile changes, such risk assessment should be rerun and—if deemed necessary—the ICP should be revised to fit the changed risk profile. 1.2   Top-level management commitment to compliance The top-level management should continuously and distinctly express their commitment to a culture of compliance in order to lead by example. Regularly communicating corporate commitment to compliance to all employees and defining expectations, both orally and in writing, is considered vital in order to encourage such a culture of compliance.[14] We further suggest such making sure this commitment—including the way it was expressed—is well-documented. Furthermore, any expressed commitment to compliance should be reviewed by counsel to ensure the statement itself does not cause regulatory concerns in light of applicable anti-boycott law. For example, a statement made by a German resident noting, “Our company fully complies with all U.S. sanctions,” is itself a breach of applicable law in Germany, specifically section 7 of the German Trade Ordinance. 1.3   Organization structure, responsibilities and resources According to the EU guidelines, companies should create an internal organizational chart in order to define responsibilities and assign functions to various employees. It is also suggested that companies designate at least one person in control of the overall compliance commitment (in some EU Member States this person must be part of the top-level management)and at least one employee in charge of the dual-use trade control function.[15] The personnel overseeing compliance with dual-use regulations needs to be authorized to stop transactions and has to be guarded from potential conflicts of interest. Additionally, companies are advised to give these personnel access to relevant legislation, especially the latest lists of controlled goods and embargoed or sanctioned destinations and entities, and to gather all relevant compliance-related documents (policies and procedures) and assemble them in a “compliance manual.” 1.4   Training and awareness raising Companies should also require periodic training (in the form of external seminars or in-house training events, etc.) to keep the control staff up-to-date with the dual-use regulations and the company’s ICP.[16] Training sessions may also include lessons learned from performance reviews. Moreover, as potential compliance issues are a concern at all relevant levels of a company, measures to raise awareness for such issues should be taken accordingly. 1.5   Transaction screening process and procedures Establishing standardized transaction processes and procedures can help ensure compliance with relevant export law. This is best achieved by collecting and analysing all relevant information concerning item classification, transaction risk assessment, license determination and post-licensing controls.[17] Even if all necessary information is readily available, it remains challenging to verify a certain item classification from a legal perspective as the performance characteristics of an item need to be checked against the EU and national dual-use control lists. This classification regularly demands cooperation between different departments of a company, such as a cooperation between the competent technical department and the legal team.[18] Companies may also directly contact the competent authority and ask for assistance with the classification after providing a detailed technical description of the respective item. At the competent authorities, such mix of personnel is mirrored, e.g. the competent German authority, the Federal Office for Economic Affairs and Export Control (BAFA), employs both (legally trained) engineers / technicians and lawyers. 1.6   Transaction risk assessment Companies also need to ascertain whether their counterparties (intermediaries, purchasers, consignees or end users) are subject to any embargoes or sanctions. The guidance of the EU Commission proposes acquiring end-use statements from customers, checking the reliability of end users with the national competent authority and to giving attention to diversion risk indicators. If information learned or acquired from the competent authority gives cause for concern, procedures must be in place to avert any export without the authority’s explicit permit.[19] 1.7   Licensing The company should ensure that it has all relevant contact details of the competent control authority. Moreover, the exporter should be aware that exports via cloud services or personal baggage and other activities such as providing technical assistance and brokering are subject to dual-use control measures.[20] 1.8   Post-licensing controls A final check should be conducted to make sure that all steps ensuring compliance were duly taken and that licenses have not been invalidated since their issuance due to changes of the details of the exporter, the intermediaries or the end users.[21] A procedure to stop or suspend the export—if necessary—should be implemented. Note that companies are still obligated to independently investigate the lawfulness of the transaction.[22] 1.9   Performance review, audits, reporting and corrective actions According to the guidelines, it is essential to implement procedures that regularly analyse, test, evaluate, and revise the company’s ICP (e.g., in the form of targeted and documented audits).[23] Furthermore, specific reporting procedures should be in place in order to enable the company to take the required action when a case of noncompliance is suspected or has occurred. Employees must also feel secure to express concerns about noncompliance or the operational reliability of the ICP. Any suspected noncompliance should be documented. After taking effective corrective actions, the relevant personnel should be informed of those measures. 1.10   Record-keeping and documentation The company should establish policies for legal document storage, record management and traceability of trade control-related activities.[24] This may be legally required in some cases, but it also generally renders the search for legal documents more effective. The relevant EU and national legal provisions for record-keeping (period of safekeeping, scope of documents, etc.) should be reviewed before establishing such a filing system. Additionally, it is suggested that the company keep track of past contacts with responsible authorities. 1.11   Physical and information security Due to the generally high sensitivity of dual-use items, companies are requested to introduce procedures to prevent the unapproved access to and removal of controlled items. With regard to physical items, the establishment of restricted access areas, personnel access or exit controls or physically safeguarding the respective item should be considered. To assure the security of physically intangible technology, the guideline recommends, among other steps, that the company install antivirus programs, file encryption and firewalls[25]. 2.   Outlook Taking into account both the new EU guidance and the Framework for OFAC Compliance Commitments,[26] there is a clear trend visible from authorities to voice and detail their expectations on how companies should address sanctions and export control compliance. In turn, it can be expected that noncompliance with such expectations will increasingly be under enhanced regulatory scrutiny. ___________________    [1]   See: Press release of the Council of the EU: Turkey's illegal drilling activities in the Eastern Mediterranean: Council adopts framework for sanctions, available online at: https://www.consilium.europa.eu/en/press/press-releases/2019/11/11/turkey-s-illegal-drilling-activities-in-the-eastern-mediterranean-council-adopts-framework-for-sanctions/.    [2]   A. Smith, S. Connor and R. Roeder, U.S., EU, and UN Sanctions: Navigating the Divide for International Business, Bloomberg, 2019, ISBN 978-1-68267-281-5. The first chapter can be found online at: https://www.gibsondunn.com/wp-content/uploads/2019/11/Smith-Connor-Roeder-US-EU-and-UN-Sanctions-Navigating-the-Divide-for-International-Businesses-Bloomberg-Law-2019.pdf.    [3]   https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32019H1318&from=EN – page 3/18.    [4]   E.g. for Germany, please see: Internal Compliance Programmes – ICP - Company-internal export control systems, available online at: www.bafa.de › Downloads › afk_merkblatt_icp_en.    [5]   https://www.bis.doc.gov/index.php/documents/pdfs/1641-ecp/file.    [6]   https://icp.acis.state.gov/.    [7]   https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32019H1318&from=EN – page 1/18.    [8]   https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32019H1318&from=EN – page 3/18.    [9]   Please note that the EU ICP guidance makes reference to the 2011 Wassenaar Arrangement Best Practice Guidelines on Internal Compliance Programmes for Dual-Use Goods and Technologies (available online at https://www.wassenaar.org/app/uploads/2015/06/2-Internal-Compliance-Programmes.pdf); the “Best Practice Guide for Industry” from the Nuclear Suppliers Group (NSG), click here; the ICP elements in the Commission Recommendation 2011/24/EU; the results from the fourth Wiesbaden Conference (2015) on “Private Sector Engagement in Strategic Trade Controls: Recommendations for Effective Approaches on United Nations Security Council Resolution 1540 (2004) Implementation”; and the 2017 United States Export Control and Related Border Security Program ICP Guide website (available online at http://icpguidelines.com/). [10]   https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32019H1318&from=EN – page 3/18. [11]  Council Regulation (EC) 428/2009, regularly referred to as the EU Dual-Use Regulation, has set up an EU regime for the control of export, transit and brokering of dual-use items in order to contribute to international peace and security by precluding the proliferation of nuclear, chemical, or biological weapons and their means of delivery. To adapt to the rapidly changing technological, economic and political circumstances, the EU Commission presented a proposal in September 2016 to update and expand the existing rules that was supported by the European Parliament in its first report on the matter.  On June 5, 2019, the Council issued its own parameters for negotiations with the European Parliament seeking a more limited recast of the dual-use regulation.  Thereby the discussion mainly focuses on the classification of cyber surveillance technologies as dual-use goods and the possibility of a resulting discrimination of EU companies.  Considering the ongoing discussions, we do not expect the implementation to take place in the coming weeks.  The progress of the respective discussion can be viewed at : http://www.europarl.europa.eu/legislative-train/theme-europe-as-a-stronger-global-actor/file-review-of-dual-use-export-controls. [12]   https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32019H1318&from=EN – page 3/18. [13]   https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32019H1318&from=EN – page 4/18. [14]   https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32019H1318&from=EN – pages 5/18 and 6/18. [15]   https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32019H1318&from=EN – page 6/18. [16]   https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32019H1318&from=EN – page 7/18. [17]   https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32019H1318&from=EN – page 7/18. [18]   For best practices from a company perspective please see: Müller, Alexandra / Groba, Alexander in AW-Prax 2019 – page 300. [19]   https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32019H1318&from=EN – page 9/18. [20]   https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32019H1318&from=EN – page 10/18. [21]   https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32019H1318&from=EN – page 10/18. [22]   Müller, Alexandra / Groba, Alexander in AW-Prax 2019 – page 303. [23]   https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32019H1318&from=EN – page 10/18. [24]   https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32019H1318&from=EN – page 11/18. [25]   https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32019H1318&from=EN – page 12/18. [26]   https://www.treasury.gov/resource-center/sanctions/Documents/framework_ofac_cc.pdf. The following Gibson Dunn lawyers assisted in preparing this client update: Judith Alison Lee, Patrick Doris, Michael Walther, R.L. Pratt and Richard Roeder. Gibson Dunn's lawyers are available to assist in addressing any questions you may have regarding the above developments.  Please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any of the following leaders and members of the firm's International Trade practice group: United States: Judith Alison Lee - Co-Chair, International Trade Practice, Washington, D.C. (+1 202-887-3591, jalee@gibsondunn.com) Ronald Kirk - Co-Chair, International Trade Practice, Dallas (+1 214-698-3295, rkirk@gibsondunn.com) Jose W. Fernandez - New York (+1 212-351-2376, jfernandez@gibsondunn.com) Marcellus A. McRae - Los Angeles (+1 213-229-7675, mmcrae@gibsondunn.com) Adam M. Smith - Washington, D.C. (+1 202-887-3547, asmith@gibsondunn.com) Stephanie L. Connor - Washington, D.C. (+1 202-955-8586, sconnor@gibsondunn.com) Christopher T. Timura - Washington, D.C. (+1 202-887-3690, ctimura@gibsondunn.com) Ben K. Belair - Washington, D.C. (+1 202-887-3743, bbelair@gibsondunn.com) Courtney M. Brown - Washington, D.C. (+1 202-955-8685, cmbrown@gibsondunn.com) Laura R. Cole - Washington, D.C. (+1 202-887-3787, lcole@gibsondunn.com) R.L. Pratt - Washington, D.C. (+1 202-887-3785, rpratt@gibsondunn.com) Samantha Sewall - Washington, D.C. (+1 202-887-3509, ssewall@gibsondunn.com) Audi K. Syarief - Washington, D.C. (+1 202-955-8266, asyarief@gibsondunn.com) Scott R. Toussaint - Washington, D.C. (+1 202-887-3588, stoussaint@gibsondunn.com) Europe: Peter Alexiadis - Brussels (+32 2 554 72 00, palexiadis@gibsondunn.com) Nicolas Autet - Paris (+33 1 56 43 13 00, nautet@gibsondunn.com) Attila Borsos - Brussels (+32 2 554 72 10, aborsos@gibsondunn.com) Patrick Doris - London (+44 (0)207 071 4276, pdoris@gibsondunn.com) Sacha Harber-Kelly - London (+44 20 7071 4205, sharber-kelly@gibsondunn.com) Penny Madden - London (+44 (0)20 7071 4226, pmadden@gibsondunn.com) Steve Melrose - London (+44 (0)20 7071 4219, smelrose@gibsondunn.com) Benno Schwarz - Munich (+49 89 189 33 110, bschwarz@gibsondunn.com) Michael Walther - Munich (+49 89 189 33-180, mwalther@gibsondunn.com) Richard W. Roeder - Munich (+49 89 189 33-160, rroeder@gibsondunn.com) © 2019 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
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December 3, 2019

A Current Guide to Direct Listings

Click for PDF What is a direct listing? Direct listings have increasingly been gaining attention as a means for a private company to go public. A direct listing refers to the listing of a privately held company’s stock for trading on a national stock exchange (either the NYSE or Nasdaq) without conducting an underwritten offering, spin-off or transfer quotation from another regulated stock exchange. Under current stock exchange rules, direct listings involve the registration of a secondary offering of a company’s shares on a registration statement on Form S-1 or other applicable registration form filed with, and declared effective by, the SEC.[1] Existing shareholders, such as employees and early-stage investors, whose shares are registered for resale are able to sell their shares on the applicable exchange, but are not obligated to do so, providing flexibility and value to such shareholders by creating a public market and liquidity for the company’s stock. Upon listing of the company’s stock, the company becomes subject to the reporting and governance requirements applicable to publicly traded companies, including periodic reporting requirements under the Securities Exchange Act of 1934, as amended, and governance requirements of the applicable exchange. Companies may pursue a direct listing to provide liquidity and a broader trading market for its shareholders; however, the listing company can also benefit. Forecasting a direct listing may make the listing company’s equity more attractive to potential investors while the company is still private and provide greater process control to the company as it goes public. For instance, the traditional roadshow has been replaced in some direct listings by an investor day whereby the company invites investors to learn about the company one-to-many, such as via a webcast, which can be considered more democratic as all investors have access to the same educational materials at once. In addition, equity that will be publicly traded can serve as a more attractive acquisition currency, both before and after listing. Most significantly, listing provides a company with optionality to use the public capital markets to raise cash, typically lowering its cost of capital and increasing flexibility in capital planning. Amendments to the NYSE’s current rules that were proposed by the NYSE on November 26, 2019 would allow a company to conduct a direct listing while publicly selling shares in the opening auction on the first day of trading on the exchange. These proposed rules would create an opportunity for primary offerings through direct listings. What are the benefits of a direct listing as compared to an IPO? Immediate Benefits to Existing Shareholders. All shareholders whose shares are registered on the resale shelf registration statement will have the opportunity to participate in the first day of trading of the company’s stock. Shareholders who choose to sell are able to do so at market trading prices, rather than only at the initial price to the public set in an IPO. The ability to sell at market prices on the first day of a listing can be a significant benefit to existing shareholders who elect to sell. However, this benefit assumes there is sufficient market demand for the shares offered for resale. Potentially Wider Initial Market Participation. The traditional IPO process includes a focused set of participants, and institutional buyers tend to feature prominently in the initial allocation of shares to be sold by the underwriting syndicate. In a direct listing, any prospective purchasers of shares are able to place orders with their broker-dealer of choice, at whatever price they believe is appropriate, and such orders become part of the initial reference price-setting process. Flexibility in Timing of Public Announcement. IPO marketing has become more flexible since the introduction of rules providing for “testing-the-waters” communications by Emerging Growth Companies and, starting December 3, 2019, all companies. However, a direct listing allows a company to avoid the rigidity of the traditional roadshow conducted for a specified period of time following the publicly announced launch of an IPO and allows it to tailor marketing activities to the specific considerations underlying the direct listing. These marketing efforts may include one or more investor days and a roadshow-like presentation, conducted at times deemed most advantageous (although the applicable registration statement must still be publicly filed for at least 15 days in advance of any such marketing efforts). Although the approximate timing of the direct listing can be inferred from the status of the publicly filed registration statement, the company may have more flexibility as to the day its shares commence trading on the applicable stock exchange. Brand Visibility. As direct listings are still a novel concept in U.S. capital markets, any direct listing with moderate success will likely draw broad interest from market participants and relevant media. This effect is multiplied when the listing company has a well-recognized brand name. No Underwriting Fees. A direct listing can save money by allowing companies to avoid underwriting discounts and commissions on the shares sold in the IPO. However, the company will still incur significant fees to market makers or specialists, as applicable, independent valuation agents, auditors, legal counsel, and a financial advisor. No Lock-up Agreements. Existing management and significant shareholders are not typically subject to the restrictions imposed by 180-day lock-up agreements standard in IPOs. Notwithstanding, as practice evolves, investors may expect certain key players will be subject to lock-up arrangements, as was the case with Spotify’s largest non-management shareholder. What are issues to consider in selecting a direct listing instead of an IPO? Direct Listing-specific Risks. Traditional IPOs offer certain advantages that are not currently present in direct listings. Going public without the structure of an IPO process is not without risk, such as the need to obtain research coverage in the absence of an underwriting syndicate that has research analysts or the need to educate investors on the company’s business model. Any company considering a direct listing should contemplate whether its investor relations apparatus is capable of playing an outsized role in coordinating marketing efforts and outreach to potential investors. Notably, in a direct listing, the listing company’s management plays no role in setting the initial reference price, and certain market-making activities conducted by the underwriting syndicate may be unavailable. This may present unacceptable risks for companies that may otherwise be poised to undertake a direct listing. Establishing a Price Range and Initial Reference Price. No marketing efforts are permissible without a compliant preliminary prospectus on file with the SEC, and such prospectus must include an estimated price range. In a traditional IPO, the cover page of the preliminary prospectus contains a price range of the anticipated initial sale price of the shares. In a direct listing, the current market practice is to describe how the initial reference price is derived (e.g., by buy and sell orders collected by the applicable exchange from various broker-dealers). These buy and sell orders have in the past been largely determined with reference to high and low sales prices per share in recent private transactions of the subject company. In cases where a company does not have such transactions to reference, additional information will be necessary to educate and assist investors and help establish an initial bid price. In addition, the listing company may elect to increase the period between the effectiveness of its registration statement and its first day of trading, thereby allowing time for additional buy and sell orders to be placed. The financial advisor to the company will play an important role in this process, as discussed below. Financial Advisors and their Independence. The rules of both the NYSE and Nasdaq require that the listing company appoint a financial advisor to provide an independent valuation of the listing company’s “publicly held” shares and, in practice, assist the applicable exchange’s market maker or specialists, as applicable, in setting a reference price. In past direct listings, in particular those involving the NYSE, the financial advisor that served this role was not the financial advisor the listing company engaged to advise generally, including to assist the company define objectives for the listing, position the equity story of the company, advise on the registration statement, and assist in preparing presentations and other public communications. The financial advisor that values the “publicly held” shares and assists the applicable exchange’s market maker or specialists, as applicable, must be independent, which under the relevant rules disqualifies any broker-dealer that has provided investment banking services to the listing company within the 12 months preceding the date of the valuation. Shares to be Registered. In a direct listing, a company generally registers for resale all of its outstanding common equity which cannot then be sold pursuant to an applicable exemption from registration (such as Rule 144), including those subject to registration rights obligations. The company may register shares held by affiliates and non-affiliates who have held the shares for less than one year or otherwise did not meet the requirements for transactions without restriction under Rule 144. Companies may also register shares held by employees to address any regulatory concerns that resales of shares by employees occurring around the time of the direct listing may not have been entitled to an exemption from registration under the Securities Act. All shares subject to registration may be freely resold pursuant to the registration statement only as long as the registration statement remains effective and current. The company will typically bear the related costs. What rules are applicable to a direct listing? Background The direct listing rules of both the NYSE and Nasdaq Global Select Market are substantially similar and are structured as an exception to each exchange’s requirement concerning the aggregate market value of the company to be listed. Prior to the direct listing rules, companies that did not previously have their common equity registered under the Exchange Act were required to show an aggregate market value of “publicly held” shares in excess of $100 million ($110 million for Nasdaq Global Select Market, under certain circumstances), such market value being established by both an independent third-party valuation and recent trading prices in a trading market for unregistered securities (commonly referred to as the Private Placement Market). “Publicly held” shares include those held by persons other than directors, officers and presumed affiliates (shareholders holding in excess of 10%). The Private Placement Market includes trading platforms operated by any national securities exchange or registered broker-dealers. Generally, in a direct listing, the relevant company either (i) does not have its shares traded on a Private Placement Market prior its listing or (ii) underlying trading in the Private Placement Market is not sufficient to provide a reasonable basis for reaching conclusions about a company’s trading price. Recent Expansion of Markets On August 15, 2019, Nasdaq submitted to the SEC proposed rule changes related to direct listings on the Nasdaq Global Market and Nasdaq Capital Market, the second- and third-tier Nasdaq markets, respectively. On December 3, 2019, subsequent to an amendment of its proposal by Nasdaq filed on November 26, 2019, the SEC approved Nasdaq’s proposed rule changes. The effect of the rule changes is that if the company to be listed does not have recent sustained trading activity in a Private Placement Market, and thereby must rely on an independent third-party valuation consistent with the rules described above, such calculation must reflect a (i) tentative initial bid price, (ii) market value of listed securities and (iii) market value of publicly held shares that each exceed 200 percent of the otherwise applicable requirements. Requirements for a Direct Listing The direct listing rules discussed above were intended to provide relief for privately-held “unicorns,” or companies that are otherwise sufficiently capitalized and which do not need to raise money. Each exchange’s listing standards applicable to direct listings by U.S. companies are summarized, by relevant exchange, in the table that follows: OVERVIEW OF LISTING STANDARDS APPLICABLE TO DIRECT LISTINGS   NYSE NASDAQ GLOBAL SELECT MARKET NASDAQ GLOBAL MARKET NASDAQ CAPITAL MARKET Market Value of Publicly Held Shares (i.e., held by persons other than directors, officers and presumed affiliates) The listing company must have a recent valuation from an independent third party indicating at least $250 million in aggregate market value of publicly held shares. (Rule 102.01A(E))[2] The listing company must have a recent valuation from an independent third party indicating at least $250 million in aggregate market value of publicly held shares. (Rule IM-5315-1(b))[2] The listing company must have a recent valuation[3] from an independent third party indicating in excess of $16 million to $40 million in aggregate market value of publicly held shares, depending on the financial standard met below. (Rule 5405) The listing company must have a recent valuation[3] from an independent third party indicating in excess of $10 million to $30 million in aggregate market value of publicly held shares, depending on the financial standard met below. (Rule 5505) Financial Standards The listing company is required to meet one of the following applicable financial standards: (i)     Each of (a) aggregate adjusted pre-tax income for the last three fiscal years in excess of $10 million, (b) with at least $2 million in each of the two most recent fiscal years and (c) positive income in each of the last three fiscal years (the “NYSE Earnings Test”). (ii)   Global market capitalization of $200 million (the “Global Market Capitalization Test”). The listing company is required to meet one of the following applicable financial standards: (i)     Each of (a) aggregate adjusted pre-tax income for the last three fiscal years in excess of $11 million, (b) with at least $2.2 million in each of the two most recent fiscal years and (c) positive income in each of the last three fiscal years (the “Nasdaq Earnings Standard”). (ii)   Each of (a) average market capitalization in excess of $550 million over the prior 12 months, (b) $110 million in revenue for the previous fiscal year and (c) aggregate cash flows for the last three fiscal years in excess of $27.5 million and positive cash flows for each of the last three fiscal years (the “Capitalization with Cash Flow Standard”). (iii) Each of (a) average market capitalization in excess of $850 million over the prior 12 months and (b) $90 million in revenue for the previous fiscal year (the “Capitalization with Revenue Standard”). (iv)  Each of (a) market capitalization in excess of $160 million, (b) total assets in excess of $80 million, and (c) stockholders’ equity in excess of $55 million (the “Assets with Equity Standard”). The listing company is required to meet one of the following applicable financial standards: (i)     Each of (a) aggregate adjusted pre-tax income in excess of $1 million in the latest fiscal year or in two of the last three fiscal years and (b) Stockholders’ equity in excess of $15 million. (ii)   Each of (a) Stockholders’ equity in excess of $30 million and (b) two years of operating history. (iii) Market value of listed securities in excess of $150 million. (iv)  Total assets and total revenue in excess of $75 million in the latest fiscal year or in two of the last three fiscal years. The listing company is required to meet one of the following applicable financial standards: (i)     Each of (a) Stockholders’ equity in excess of $15 million and (b) two years of operating history. (ii)   Each of (a) Stockholders’ equity in excess of $4 million and (b) market value of listed securities in excess of $100 million. (iii) Total assets and total revenue in excess of $75 million in the latest fiscal year or in two of the last three fiscal years. Distribution Standards The listing company must meet all of the following distribution standards: (i)     400 round lot shareholders; (ii)   1.1 million publicly held shares; and (iii) Minimum initial reference price of $4.00. The listing company must meet all of the following liquidity requirements: (i)     450 round lot shareholders or 2,200 total shareholders; (ii)   1.25 million publicly held shares; and (iii) Minimum initial reference price of $4.00. The listing company must meet all of the following distribution standards: (i)     400 round lot shareholders; (ii)   1.1 million publicly held shares; and (iii) Minimum initial reference price of $8.00. The listing company must meet all of the following liquidity requirements: (i)     300 round lot shareholders; (ii)   1 million publicly held shares; and (iii) Minimum initial reference price of $8.00 OR closing price of $6.00.[4] Engagement of Financial Advisor Any valuation used in connection with a direct listing must be provided by an entity that has significant experience and demonstrable competence in the provision of such valuations. (Rule 102.01A(E)) A valuation agent will not be deemed to be independent if (Rule 102.01A(E)): (i)     At the time it provides such valuation, the valuation agent or any affiliated person or persons beneficially own in the aggregate, as of the date of the valuation, more than 5% of the class of securities to be listed, including any right to receive any such securities exercisable within 60 days. (ii)   The valuation agent or any affiliated entity has provided any investment banking services to the listing applicant within the 12 months preceding the date of the valuation. For purposes of this provision, "investment banking services" includes, without limitation, acting as an underwriter in an offering for the issuer; acting as a financial adviser in a merger or acquisition; providing venture capital, equity lines of credit, PIPEs (private investment, public equity transactions), or similar investments; serving as placement agent for the issuer; or acting as a member of a selling group in a securities underwriting. (iii) The valuation agent or any affiliated entity has been engaged to provide investment banking services to the listing applicant in connection with the proposed listing or any related financings or other related transactions. Any valuation used in connection with a direct listing must be provided by an entity that has significant experience and demonstrable competence in the provision of such valuations. (Rule IM-5315-1(e)) A valuation agent shall not be considered independent if (Rule IM-5315-1(f)): (i)     At the time it provides such valuation, the valuation agent or any affiliated person or persons beneficially own in the aggregate, as of the date of the valuation, more than 5% of the class of securities to be listed, including any right to receive any such securities exercisable within 60 days. (ii)   The valuation agent or any affiliated entity has provided any investment banking services to the listing applicant within the 12 months preceding the date of the valuation. For purposes of this provision, "investment banking services" includes, without limitation, acting as an underwriter in an offering for the issuer; acting as a financial adviser in a merger or acquisition; providing venture capital, equity lines of credit, PIPEs (private investment, public equity transactions), or similar investments; serving as placement agent for the issuer; or acting as a member of a selling group in a securities underwriting. (iii) The valuation agent or any affiliated entity has been engaged to provide investment banking services to the listing applicant in connection with the proposed listing or any related financings or other related transactions. Same as the Nasdaq Global Select Market Same as the Nasdaq Global Select Market Upon satisfaction of the above requirements of the applicable exchange, the exchange will generally file a certification with the SEC, confirming that its requirements have been met by the listing company. After such filing, the company’s registration statement may be declared effective by the SEC (assuming the SEC review has run its course). In practice, the SEC has reviewed registration statements that contemplate a direct listing in substantially the same manner it reviews traditional IPO registration statements, with some additional focus on process as direct listing practice and the related rules evolve. After the registration statement is declared effective by the SEC, the company becomes subject to the governance requirements of the applicable exchange (subject to compliance periods) and the reporting requirements under the Exchange Act. The company may then establish the day its equity will commence trading in consultation with the applicable exchange, which could be the same day as the SEC declares the registration statement effective, assuming the exchange’s market maker or specialists, as applicable, and the financial advisor appointed by the company are able to determine an initial reference price. NYSE’s proposed rule changes: Primary capital raise via direct listing Historically, companies have not raised fresh capital as part of the direct listing process. On November 26, 2019, the NYSE filed proposed rules with the SEC that seek to allow companies to publicly raise capital through a direct listing. The NYSE’s proposal would allow a company to sell shares on its own behalf, without underwriters, in addition to or in place of a secondary offering by shareholders. Although questions about their application remain, the NYSE’s proposed rules, if adopted, could potentially revolutionize the way in which companies go public. Companies hoping to conduct a primary offering while listing pursuant to the NYSE’s proposed rules would be required to either: sell at least $250 million in the opening auction on the first day of listing, thereby ensuring that there will be at least $250 million in public float after the first trade; or if a listing company sells less than $250 million in market value of shares in the opening auction, the exchange will require that the aggregate of the market value of publicly held shares immediately prior to listing and the market value of shares sold by the company in the opening auction is at least $250 million. In addition, the NYSE has proposed a new compliance period to its requirement that a listing company have 400 round lot shareholders. Under the proposed rules, any company conducting a direct listing that qualifies under the standard described in the next paragraph below would be required to demonstrate compliance with the round-lot shareholder requirement within 90 trading days of the listing date, or be subject to the NYSE’s standard compliance procedures. To benefit from the NYSE’s proposed “Distribution Standard Compliance Period,” a company must: conduct a primary offering in which the company sells at least $250 million in market value of shares in the opening auction on the initial listing date; conduct a secondary offering that demonstrates $350 million in market value of publicly held shares; or conduct a primary offering in which the aggregate of the market value of publicly held shares immediately prior to listing and the market value of shares sold by the company in the opening auction is at least $350 million. Pursuant to Section 19(b)(2) of the Securities Act, the SEC has 45 days to either approve or disapprove the proposed rule change or institute proceedings to determine whether the proposed rule change should be disapproved. The SEC could also extend the 45-day period by an additional 45 days if it determines that a longer period is appropriate and publishes the reasons for such determination, as it did with the recently approved Nasdaq rules. Nasdaq has not to date introduced a proposed rule change that would allow primary registered offerings concurrently with a direct listing. However, Nasdaq is expected to introduce a similar proposal in order to allow it to best compete with the NYSE as the direct listing practice evolves. Conclusion Direct listings are a sign of the times. As U.S. companies raise increasingly large amounts of capital in the private markets, the public capital markets need to provide a wider variety of means for a private company to enter the public capital markets and provide liquidity to existing shareholders. Although direct listings will undoubtedly provide new opportunities for entrepreneurial companies with a well-recognized brand name or easily understood business model, we do not expect direct listings to replace IPOs any time soon. Direct listing practice is evolving and involves new risks and speedbumps. Any company considering an entry to the public capital markets through a direct listing is encouraged to carefully consider the risks and benefits in consultation with counsel and financial advisors. Members of the Gibson Dunn Capital Markets team are available to discuss strategy, options and considerations as the rules and practice concerning direct listings evolve. [1]   Many foreign private issuers have listed their shares on U.S. exchanges without a simultaneous U.S. capital raising, seeking such listing following the company filing a registration statement on Form 20-F under the Securities Exchange Act of 1934, as amended, and, where those shares are to be traded in the form of American depositary shares evidenced by American depositary receipts, the depositary bank filing a registration statement on Form F-6 under the Securities Act of 1933, as amended (a so-called Level II ADR Facility). Such Level II ADR facilities are outside the scope of this article and should be separately considered with the advice of counsel. [2]   There must be an independent valuation where a company goes public without an underwriting syndicate that would otherwise represent to the applicable exchange that such exchange’s distribution requirements will be met by the contemplated offering. If consistent and reliable private market trading quotes are available, both the independent valuation and valuation based on private market trading quotes must show a market value of “publicly held” shares in excess of $100 million ($110 million for Nasdaq Global Select Market, under certain circumstances). [3]   In lieu of a valuation for listings on the Nasdaq Global Market and Nasdaq Capital Market, the exchange may accept “other compelling evidence” that the (i) tentative initial bid price, (ii) market value of listed securities and (iii) market value of publicly held shares each exceed 250 percent of the otherwise applicable requirements. Under the rules, as amended, such compelling evidence is currently limited to cash tender offers by the company or an unaffiliated third party that meet certain other requirements. [4]      To qualify under the closing price alternative, the listing company must have: (i) average annual revenues of $6 million for three years, or (ii) net tangible assets of $5 million, or (iii) net tangible assets of $2 million and a three-year operating history, in addition to satisfying the other financial and liquidity requirements listed above. If listing on the Nasdaq Capital Markets under the NCM Listed Securities Standard in reliance on the closing price alternative, such closing price must be in excess of $4.00. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact any member of the Gibson Dunn team, the Gibson Dunn lawyer with whom you usually work in the firm’s Capital Markets or Securities Regulation and Corporate Governance practice groups, or the authors: J. Alan Bannister - New York (+1 212-351-2310, abannister@gibsondunn.com) Hillary H. Holmes - Houston (+1 346-718-6602, hholmes@gibsondunn.com) Glenn R. Pollner - New York (+1 212-351-2333, gpollner@gibsondunn.com) Evan Shepherd* - Houston (+1 346-718-6603, eshepherd@gibsondunn.com) Please also feel free to contact any of the following practice leaders: Capital Markets Group: Andrew L. Fabens - New York (+1 212-351-4034, afabens@gibsondunn.com) Hillary H. Holmes - Houston (+1 346-718-6602, hholmes@gibsondunn.com) Stewart L. McDowell - San Francisco (+1 415-393-8322, smcdowell@gibsondunn.com) Peter W. Wardle - Los Angeles (+1 213-229-7242, pwardle@gibsondunn.com) Securities Regulation and Corporate Governance Group: Elizabeth Ising - Washington, D.C. (+1 202-955-8287, eising@gibsondunn.com) James J. Moloney - Orange County, CA (+1 949-451-4343, jmoloney@gibsondunn.com) Lori Zyskowski - New York (+1 212-351-2309, lzyskowski@gibsondunn.com) *Admitted in New York; Not admitted in Texas, practicing under the supervision of the Firm. © 2019 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
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November 26, 2019

U.S. Congress Passes The Hong Kong Human Rights and Democracy Act of 2019; Awaiting Presidential Signature

Click for PDF On November 21, 2019, amid mounting tensions between China and Hong Kong, the U.S. Congress passed the Hong Kong Human Rights and Democracy Act of 2019 (the “Bill”)[1] and sent it to the President for his signature.  The Bill, which aims to protect civil rights in Hong Kong and to deter human rights violations in the territory (including by punishing those who commit them), was passed by supermajorities in both houses of Congress—the House of Representatives approved the Bill by a 417-1 margin, while the Bill received unanimous support in the Senate.[2]  As of this writing, the President has not signed the legislation. On November 22, 2019, President Trump suggested that he might veto the Bill in order to prioritize a trade deal with China, despite the fact that the President’s ability to exercise such authority will be limited because the Bill passed both houses of Congress with rare veto-proof majorities.  Although the U.S. Congress has the power to create the law, the U.S. President has sole enforcement authority, and President Trump may still be able to express his displeasure with the Bill by narrowly interpreting the law’s provisions.  We would expect that the President could announce his desire to narrowly interpret the law in a signing statement made simultaneous with his signing of the Bill. The Bill has received widespread support from the Hong Kong protestors, whose activities over the past several months have often included calls on Washington to show its support for their movement. On the other hand, the Bill has been met with strong opposition in Hong Kong and China due to concerns that the legislation could disrupt economic stability in Hong Kong, as well as worsen the existing trade relationship between Hong Kong and the United States.[3] In Hong Kong, Chief Executive Carrie Lam has said that foreign interference in Hong Kong’s internal affairs is “totally unacceptable” and that any sanctions imposed by Washington would only serve to complicate matters further.[4] Beijing has also characterized the Bill as an interference in China’s domestic affairs and has threatened to take “strong countermeasures” against the United States if the Bill is implemented.[5] Overview of the Hong Kong Human Rights and Democracy Act 2019 If enacted, the Bill would amend the United States-Hong Kong Policy Act of 1992 (the “1992 HK Act”), the primary legislation that governs the United States’ relationship with Hong Kong. The 1992 HK Act statute allows Hong Kong to be treated separately from mainland China on various economic matters such as trade. An earlier version of the Bill had been introduced in 2014 in response to the “Umbrella Revolution” that took place in Hong Kong that year;[6] and an updated version was again introduced in 2017. However, the Bill only gained legislative traction this year as violence in Hong Kong escalated. The protests, which have spanned more than 22 weeks, originally began in June. They were spurred by a now-withdrawn bill that would have allowed extraditions from Hong Kong to mainland China, among other jurisdictions, a move that many Hong Kongers viewed as an attempt to circumvent the “one country, two systems” rule and erode human rights in the territory.[7] The protests have since grown into a bigger movement, including broader demands for democracy, such as universal suffrage and the ability for Hong Kongers to elect its own leaders, as set out under the Basic Law of the Hong Kong Special Administrative Region (the “Basic Law”).[8] Other demands that the protestors have made also include calls to establish an independent commission of inquiry to look into alleged police brutality against protestors. The Bill, if signed into law, will increase the United States’ scrutiny over the situation in Hong Kong. According to the Bill, the objective of the legislation is to “reaffirm the principles and objectives set forth in the [1992 HK Act]”.[9] The Bill also calls for Hong Kong to remain “sufficiently autonomous from the People’s Republic of China to ‘justify treatment under a particular law of the United States, or any provision thereof, different from that accorded to the People’s Republic of China.’”[10] Similar to the 1992 HK Act, the Bill requires an annual assessment of Hong Kong’s autonomy to determine whether it should continue to be treated differently from mainland China. Additionally, the Bill introduces the potential imposition of U.S. sanctions in response to human rights violations in Hong Kong. The following is a summary of the key provisions of the Bill: Annual Certification of Hong Kong Under the provisions of the Bill, on an annual basis the U.S. Secretary of State will be required to report to the Congress the U.S. Government’s view as to whether Hong Kong retains sufficient autonomy to merit its continued enjoyment of economic treatment by the United States distinct from (and in almost all cases more favorable than) the treatment provided to the mainland.[11] Furthermore, the report must include “an assessment of the degree of any erosions to Hong Kong’s autonomy” that have an impact on a number of matters such as commercial agreements, sanctions enforcement, export controls, and any other agreements and forms of exchange involving dual-use, critical, or other sensitive technologies as a result of any action taken by the Chinese government that is inconsistent with its commitments under the Basic Law or the Sino-British Joint Declaration of 1984.[12] Importantly, under the Bill a positive assessment that allows the continued differentiated treatment between Hong Kong and mainland China does not require that Beijing allow for further democratization in Hong Kong. Annual Report on Violations of U.S. Export Control Laws and UN Sanctions in Hong Kong The Bill also requires the U.S. Secretaries of the Treasury and State to submit a separate joint report to Congress that includes: an assessment of the nature and extent of violations of U.S. export control and sanctions laws occurring in Hong Kong; an identification of items reexported from Hong Kong in violation of U.S. export control and sanctions laws, including the countries and persons to which the items were reexported to, and how such items were used; an assessment of whether sensitive dual-use items subject to U.S. export control laws are being transhipped through Hong Kong and used to develop mass surveillance programs in China; an assessment of whether China has been using Hong Kong’s status as a separate customs territory to import goods into China from Hong Kong in contravention of U.S. export control laws through certain schemes or programs that may exploit Hong Kong as a conduit for controlled sensitive technology; an assessment of whether Hong Kong has adequately enforced sanctions imposed by the United Nations (“UN”); a description of the types of goods and services transhipped or reexported through Hong Kong in violation of UN sanctions to North Korea, Iran, or other high risk jurisdictions or entities; and an assessment of whether any shortcomings in Hong Kong’s enforcement of sanctions and export controls necessitates the assignment of additional personnel to the U.S. Consulate of Hong Kong.[13] Promulgation of U.S. Sanctions in Response to Human Rights Violations in Hong Kong The Bill empowers the President to impose sanctions on individuals deemed responsible for “the extrajudicial rendition, arbitrary detention, or torture of any person in Hong Kong” or “other gross violations of internationally recognized human rights in Hong Kong.”[14] The potential sanctions that could be imposed are varied, and could include asset blocking which would effectively blacklist any identified party from participating in transactions with U.S. persons. This would be akin to adding such a party to the U.S. Specially Designated Persons and Blocked Persons List (the “SDN List”), freezing any property owned by such a party in the United States, and prohibiting any transactions involving such a party that has a U.S. nexus.[15] This would also greatly limit the designated party’s ability to engage in U.S. Dollar trade (which almost always requires clearing through a bank under U.S. jurisdiction). Other types of sanctions that could be imposed include the revocation or denial of U.S. visas currently issued or to be issued to identified individuals.[16] On the other hand, the Bill provides that visa applications from Hong Kong applicants will not be denied on the basis of “politically motivated arrest, detention, or other adverse government action.”[17] Implications of the Hong Kong Human Rights and Democracy Act 2019 Potential Impact on Hong Kong Companies Under the 1992 HK Act, Hong Kong’s distinct trading status from China has meant that it enjoys protection from punitive tariffs that the United States has imposed on China, including the tariffs that are currently in force as a result of continuing U.S.-China trade disagreements. If the Bill becomes law and Hong Kong’s protected status is eroded or removed, the impact could be significant for both Hong Kong and U.S. companies. As discussed, the Bill requires the U.S. Secretary of State to assess and certify on an annual basis, whether Hong Kong should continue to enjoy its special trade benefits vis-à-vis the United States. An adverse assessment could potentially threaten this status. Hong Kong is currently the United States’ 21st largest trading partner, with goods and services trade with Hong Kong amounting to nearly $70 billion in 2018.[18] Any limitations on trade imposed on Hong Kong could also threaten its reputation as a global financial hub – which has relied, at least in part, on its preferential trading relationship with counterparties including the United States. More than 1,300 U.S. firms currently operate in Hong Kong, and nearly every major U.S. financial firm maintains a presence in the territory, with billions of dollars of assets under management.[19] Hong Kong also risks losing ready access to U.S. technologies that are more tightly controlled when exported to China as the Bill could result in the United States imposing the same export controls on Hong Kong as it places on China. Potential Impact on U.S. Companies The impact of the Bill on the United States could be broader than trade-related losses with respect to Hong Kong. The Bill could stall trade talks between the United States and China and derail plans between the two nations to complete a “phase one” trade deal that had been announced earlier in November.[20] Even more significantly, the Bill may invite China to impose its long-threatened countersanctions against U.S. companies. Following its recent favourable World Trade Organization decision against the United States, China may find justification to impose $3.6 billion in tariffs against the United States.[21] The Bill could spur China to place additional sanctions on key U.S. imports such as aircraft, services, and wider manufacturing. Earlier in June 2019, aerospace manufacturer Boeing was reportedly in talks with Chinese air carriers for a potential $30 billion deal for the sale of wide-body aircraft, which would be one of the largest orders ever placed.[22] The deal has been threatened by the ongoing trade war, and may be subject to further delay or even cancellation if the Bill becomes law and dealings with U.S. firms become more sensitive for major Chinese entities.[23] Perhaps most aggressively, China could go as far as to proscribe some U.S. companies from doing business in China – effectively placing U.S. firms on a Chinese blacklist. Beijing has threatened such a response in the past but has yet to fully enact such a consequence. China announced the beginnings of such a list earlier in 2019 in response to the U.S. restrictions placed on Huawei Technologies Co.[24] At that time, China announced plans to establish an “unreliable entity” list that targets foreign companies or persons who China deems as severely damaging the legitimate interests of Chinese companies by, amongst others, blocking or cutting off supply chains for “non-commercial reasons.”[25] _________________________ [1]   Summary of 116thCongress (2019-2020) (Nov. 21, 2019), https://www.congress.gov/bill/116th-congress/senate-bill/1838/summary/55 [2]   See Jacob Pramuk, Congress passes Hong Kong rights bill as Trump tries to strike China trade deal, CNBC (Nov. 20, 2019), https://www.cnbc.com/2019/11/20/house-passes-hong-kong-rights-bill-amid-trump-china-trade-talks.html [3]   See Tobias Hoonhout, China Calls Senate’s Passing of Hong Kong Human Rights and Democracy Act ‘Very Disappointing’, National Review (Nov. 20, 2019), https://www.nationalreview.com/news/china-calls-senates-passing-of-hong-kong-human-rights-and-democracy-act-very-disappointing/ [4]   See Iain Marlow and Daniel Flatley, What the U.S. Congress Is and Isn’t Doing About Hong Kong, Washington Post (Nov. 18, 2019), https://www.washingtonpost.com/business/what-the-us-congress-is-and-isnt-doing-about-hong-kong/2019/11/18/d51ab226-0a19-11ea-8054-289aef6e38a3_story.html [5]   See China warns U.S. of “strong countermeasures” to looming legislation on Hong Kong, CBS News (Nov. 21, 2019), https://www.cbsnews.com/news/china-hong-kong-human-rights-and-democracy-act-2019-strong-countermeasures-beijing-today-2019-11-21/ [6]   Hong Kong Human Rights and Democracy Act, S. 2922 [7]   See Senate Passes Bill Supporting Human Rights in Hong Kong as Protests Show No Sign of Abating, Associated Press (Nov. 20, 2019), https://time.com/5733673/senate-human-rights-democracy-act-hong-kong/ [8]   See Hong Kong’s Protests Explained, Amnesty International (undated), https://www.amnesty.org/en/latest/news/2019/09/hong-kong-protests-explained/ [9]   Section 3 of the Hong Kong Human Rights and Democracy Act of 2019, S. 1838 [10]   Id. [11]   Id at Section 4 [12]   Id. [13]   Id at Section 5. [14]   Id at Section 7. [15]   Id. [16]   Id. [17]   Id at Section 4. [18]   Office of the United States Trade Representative Hong Kong Report. [19]   United States Department of State 2019 Hong Kong Policy Act Report. [20]   See US and China ‘getting close’ to trade deal, White House economic advisor Kudlow says, CNBC (Nov. 15, 2019), https://www.cnbc.com/2019/11/15/us-china-getting-close-to-trade-deal-white-house-advisor-kudlow.html [21]   See Robert Delaney, China wins WTO case to sanction US$3.6 billion in US products following anti-dumping dispute, South China Morning Post (Nov. 2, 2019), https://www.scmp.com/news/china/article/3036010/china-wins-wto-case-sanction-us36-billion-us-trade [22]   See Boeing and Chinese airlines in talks for US$30 billion mega-deal that trade war could derail, South China Morning Post (Jun. 6, 2019), https://www.scmp.com/news/china/article/3013289/boeing-and-chinese-airlines-talks-us30-billion-mega-deal-trade-war-could [23]   See Explainer: U.S.-China trade war – the levers they can pull, Reuters (Jun. 6, 2019), https://www.reuters.com/article/us-usa-trade-china-levers-explainer/explainer-u-s-china-trade-war-the-levers-they-can-pull-idUSKCN1T62KY [24]   Gibson Dunn Client Alert (May 20, 2019), Citing a National Emergency, the Trump Administration Moves to Secure U.S. Information and Communications Technology and Service Infrastructure, https://www.gibsondunn.com/?search=news&article-type=publications&s=huawei&year=&practice%5B%5D=1680 [25]   See What We Know About China’s ‘Unreliable Entities’ Blacklist, Bloomberg News (Jun. 4, 2019), https://www.bloomberg.com/news/articles/2019-06-04/understanding-china-s-unreliable-entities-blacklist-quicktake The following Gibson Dunn lawyers assisted in preparing this client update: Adam Smith, Grace Chow, Stephanie Connor, Chris Timura, Judith Alison Lee, David Lee, Brian Schwarzwalder, Scott Jalowayski, Kelly Austin, John Fadely, Fang Xue, Paul Boltz, and Yi Zhang. Gibson Dunn's lawyers are available to assist in addressing any questions you may have regarding the above developments.  Please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm's International Trade practice group, or the authors: United States: Judith Alison Lee - Co-Chair, International Trade Practice, Washington, D.C. (+1 202-887-3591, jalee@gibsondunn.com) Adam M. Smith - Washington, D.C. (+1 202-887-3547, asmith@gibsondunn.com) David C. Lee - Orange County, CA (+1 949-451-3842, dlee@gibsondunn.com) Christopher T. Timura - Washington, D.C. (+1 202-887-3690, ctimura@gibsondunn.com) Stephanie L. Connor - Washington, D.C. (+1 202-955-8586, sconnor@gibsondunn.com) Asia: Kelly Austin - Hong Kong (+852 2214 3788, kaustin@gibsondunn.com) Paul Boltz - Hong Kong (+852 2214 3723, pboltz@gibsondunn.com) Grace Chow - Singapore (+65 6507 3632, gchow@gibsondunn.com) John Fadely - Hong Kong (+852 2214 3810, jfadely@gibsondunn.com) Scott Jalowayski - Hong Kong (+852 2214 3727, sjalowayski@gibsondunn.com) Brian Schwarzwalder - Hong Kong (+852 2214 3712, bschwarzwalder@gibsondunn.com) Fang Xue - Beijing (+86 10 6502 8687, fxue@gibsondunn.com) Yi Zhang - Hong Kong (+852 2214 3988, yzhang@gibsondunn.com) © 2019 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.
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