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The Notice provides a new elective safe harbor that should reduce the practical difficulties that taxpayers face in seeking to demonstrate that their clean energy projects are eligible for the Domestic Content Bonus Credit by reducing the circumstances when taxpayers will be forced to engage in cumbersome or impractical substantiation of third-party costs.

On May 16, 2024, the IRS and Treasury issued Notice 2024-41 (the “Notice”) (here), which modifies and expands Notice 2023-38, issued last year as initial guidance for developers and investors seeking to qualify projects for the domestic content bonus credit available under sections 45, 45Y, 48, and 48E (the “Domestic Content Bonus Credit”).[1] (For a full discussion of Notice 2023-38 and the Domestic Content Bonus Credit, see our earlier client alert here.)

The Notice is a highly welcome piece of guidance. Most importantly, it provides a new elective safe harbor that should reduce the practical difficulties that taxpayers face in seeking to demonstrate that their clean energy projects are eligible for the Domestic Content Bonus Credit by reducing the circumstances when taxpayers will be forced to engage in cumbersome or impractical substantiation of third-party costs. The Notice also expands and modifies a helpful list in Notice 2023-38 categorizing components as Applicable Project Components and Manufactured Product Components for purposes of further applying the applicable requirements for the Domestic Content Bonus Credit.[2]

Background

A taxpayer is eligible to claim a Domestic Content Bonus Credit, which is an increased tax credit amount in respect of projects that meet certain requirements under sections 45 and 45Y (the “PTC”) and sections 48 and 48E (the “ITC”), if the taxpayer timely certifies to the IRS that the applicable requirements have been satisfied.[3]

The Domestic Content Bonus Credit requirements vary based on the type of Applicable Project Component. Applicable Project Components that are made primarily of steel or iron, and are structural in function, meet the Domestic Content Bonus Credit requirements if all manufacturing processes with respect to the Applicable Project Component (except metallurgical processes involving refinement of steel additives) take place in the United States (the “Steel or Iron Requirement”).[4] All other Applicable Project Components that result from a manufacturing process meet the Domestic Content Bonus Credit requirements if a certain statutory percentage (ranging from 20 percent to 55 percent) of the total of certain costs of Applicable Project Components are attributable to (i) Applicable Project Components for which all of the manufacturing processes take place in the United States and all Manufactured Product Components are of U.S. origin and (ii) “U.S. Components” (i.e., Manufactured Product Components that are mined, produced, or manufactured in the United States) of other Applicable Project Components not described in clause (i) (the “Manufactured Products Requirement”).[5]

Expansion and Modification of Existing Categorization Safe Harbor

Notice 2023-38 identified certain Applicable Project Components in utility-scale solar, wind, and energy storage projects and categorized them as subject to either the Steel or Iron Requirement or the Manufactured Products Requirement. This was a welcome development, providing highly practical guidance for taxpayers that reduced uncertainty in the threshold identification and categorization of components.

The Notice expands the guidance in Notice 2023-38 on how to identify and categorize Applicable Project Components and Manufactured Product Components of hydropower and pumped hydropower storage facilities and extends the guidance applicable to utility-scale solar to apply to ground-mount and rooftop PV systems.

The Notice also identifies additional Manufactured Product Components of inverters, solar trackers and battery containers. The Notice both states that taxpayers may treat the Applicable Project Components or Manufactured Product Components described in the Notice as having been included in the initial guidance in Notice 2023-38 and that where there are inconsistencies between the two notices regarding classifications of Applicable Project Components or Manufactured Product Components, the Notice will control.

Addition of New Elective Safe Harbor

Notice 2023-38 provided that, for purposes of satisfying the Manufactured Products Requirement, only direct material and labor costs were taken into account in the numerator and denominator when computing the applicable statutory percentage, which necessitated collecting sensitive commercial information (in documented form) from third-party suppliers or other counterparties (and then sharing that sensitive information with insurers, project buyers, lenders, tax equity investors and credit buyers). This exercise proved challenging, if not practically impossible.

The Notice eases the taxpayer’s compliance burden by providing a new safe harbor that allows taxpayers to elect to use Department of Energy-provided cost percentages (in lieu of actual costs) to determine if the Manufactured Products Requirement is met.

If a taxpayer elects to use the new safe harbor, it must apply the assigned cost percentages in the Notice to all relevant Applicable Project Components and Manufactured Product Components of the Applicable Project. If relevant Applicable Project Components and Manufactured Product Components are not enumerated in the Notice, then those components are disregarded; if the Applicable Project does not use certain Appliable Project Components and Manufactured Product Components listed in the Notice, then those components take a zero value. The safe harbor includes special provisions to facilitate its application in circumstances where a project incorporates Manufactured Products or Manufactured Product Components of the same type (e.g., a wind turbine) from both foreign and domestic sources, along with a special rule authorizing taxpayers claiming the ITC to apply the safe harbor on a project-wide basis where the project is comprised of both an energy generation and an energy storage facility.

Reliance and Certification

Taxpayers are permitted to rely on Notice 2023-38, as modified by the Notice, for purposes of claiming the Domestic Content Bonus Credit for a project on which construction begins before the date that is 90 days after publication of forthcoming proposed regulations on the domestic content requirements. Taxpayers are permitted to rely on the new safe harbor for purposes of claiming the Domestic Content Bonus Credit for a project on which construction begins before the date that is 90 days after any modification, update, or withdrawal of this new safe harbor. To rely on this new safe harbor, a taxpayer must specify on its domestic content certification statement (as described in Notice 2023-38) that the taxpayer is relying on the new safe harbor for purposes of claiming the Domestic Content Bonus Credit in respect of a project.

Observations

In our prior alert summarizing Notice 2023-38, we anticipated the commercial issues that are addressed by the Notice. We are optimistic that this Notice will allow taxpayers to take advantage of this important incentive more readily, although the all-or-nothing nature of the new safe harbor may compel some taxpayers that have good cost information with respect to some, but not all, of the Applicable Project Components to carefully weigh the pros and cons of applying the safe harbor.
Application of the new safe harbor still requires a taxpayer to identify (and document) relevant Applicable Project Components and Manufactured Product Components as having been mined, produced or manufactured in the United States, which will continue to require taxpayers to obtain information from third parties.

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[1] Unless indicated otherwise, all section references are to the Internal Revenue Code of 1986, as amended (the “Code”), and all “Treas. Reg. §” references are to the Treasury Regulations promulgated under the Code.

For a discussion of the other energy community bonus credit, please see here. For our other recent updates on guidance related to energy credits, please see the following: (1) our alerts on guidance related to transferring and receiving direct payments with respect to tax credits (available here, here, and here), (2) our alert describing proposed investment tax credit regulations (available here), (3) our alert describing proposed regulations providing guidance on the prevailing wage and apprenticeship rules (available here), (4) our alert describing tax benefits for the carbon capture industry (available here).

[2] As described in our prior client alert, applicable projects are types of energy generation or storage facilities or properties, e.g., a utility-scale photovoltaic property or land-based wind facility (an “Applicable Project”). An applicable project component is the building block of an Applicable Project (an “Applicable Project Component”). For example, Applicable Project Components of for a land-based wind facility include the tower and wind turbine. Finally, a manufactured product component is an item that is directly incorporated into an Applicable Project Component that is produced as a result of the manufacturing process (a “Manufactured Product Component”).

[3] For PTC projects, if the Domestic Content Bonus Credit is available, the section 45 or 45Y credit is increased by a maximum of 10 percent, and for ITC projects, the section 48 or 48E credit percentage is increased by a maximum of 10 percentage points. In the case of projects subject to prevailing wage and apprenticeship requirements (discussed in our prior alert here), failure to satisfy those requirements reduces the bonus credit amounts to 2 percent (for PTC projects) or 2 percentage points (for ITC projects).

[4] For purposes of this Notice, the United States includes the States, the District of Columbia, the Commonwealth of Puerto Rico, Guam, American Samoa, the U.S. Virgin Islands, and the Commonwealth of Northern Mariana Islands.

[5] The Steel or Iron Requirement applies in a manner consistent with Section 661.5(b) and (c) of title 49 of the Code of Federal Regulations (the “CFR”). 49 CFR §§ 661.1 through 661.21 (also known as the “Buy America” requirements). The Manufactured Products Requirement applies in a manner consistent with 49 CFR § 661.5(d).

The following Gibson Dunn lawyers prepared this update: Mike Cannon, Matt Donnelly, Josiah Bethards, and Austin Morris.

Gibson Dunn lawyers are available to assist in addressing any questions you may have about 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 Tax, Cleantech, or Power and Renewables practice groups, or the following authors:

Tax:
Michael Q. Cannon – Dallas (+1 214.698.3232, mcannon@gibsondunn.com)
Matt Donnelly – Washington, D.C. (+1 202.887.3567, mjdonnelly@gibsondunn.com)
Josiah Bethards – Dallas (+1 214.698.3354, jbethards@gibsondunn.com)
Austin T. Morris – Dallas (+1 214.698.3483, amorris@gibsondunn.com)

Cleantech:
John T. Gaffney – New York (+1 212.351.2626, jgaffney@gibsondunn.com)
Daniel S. Alterbaum – New York (+1 212.351.4084, dalterbaum@gibsondunn.com)
Adam Whitehouse – Houston (+1 346.718.6696, awhitehouse@gibsondunn.com)

Power and Renewables:
Peter J. Hanlon – New York (+1 212.351.2425, phanlon@gibsondunn.com)
Nicholas H. Politan, Jr. – New York (+1 212.351.2616, npolitan@gibsondunn.com)

Attorney Advertising: These materials were prepared for general informational purposes only based on information available at the time of publication and are not intended as, do not constitute, and should not be relied upon as, legal advice or a legal opinion on any specific facts or circumstances. Gibson Dunn (and its affiliates, attorneys, and employees) shall not have any liability in connection with any use of these materials. The sharing of these materials does not establish an attorney-client relationship with the recipient and should not be relied upon as an alternative for advice from qualified counsel. Please note that facts and circumstances may vary, and prior results do not guarantee a similar outcome.

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From the Derivatives Practice Group: ISDA published several reports and responses this week, including a quantitative impact study on the US Basel III proposal, and a response to CPMI and IOSCO’s variation margin practices.

New Developments

CFTC Issues Proposal on Event Contracts. On May 10, the CFTC issued a Notice of Proposed Rulemaking to further specify types of event contracts that fall within the scope of Commodity Exchange Act (CEA) section 5c(c)(5)(c) and are contrary to the public interest. The proposal includes a determination that event contracts involving each of the activities enumerated in CEA section 5c(c)(5)(c) (gaming, war, terrorism, assassination, and activity that is unlawful under any Federal or State law) are, as a category, contrary to the public interest and therefore may not be listed for trading or accepted for clearing on or through a CFTC-registered entity. Further, the proposal defines “gaming” in detail, and the proposal lists illustrative examples of gaming that include staking or risking something of value on the outcome of a political contest, an awards contest, or a game in which one or more athletes compete, or an occurrence or non-occurrence in connection with such a contest or game. Thus, event contracts involving these illustrative examples of gaming could not be listed for trading or accepted for clearing under the proposal. Comments must be received on or before July 9, 2024. [NEW]
Statement of Chairman Rostin Behnam Regarding Proposed Event Contracts Rulemaking. On May 10, CFTC Chairman Rostin Behnam remarked on his support for the proposed amendments to the Commission’s rules concerning event contracts. The Chairman remarked that the Commission proposes to further specify the types of event contracts that fall within the scope of CEA section 5c(c)(5)(C) and are contrary to the public interest. He believes that the amendments will support efforts by registered entities to comply with the CEA by more clearly identifying the types of event contracts that may not be listed for trading or accepted for clearing.
CFTC Technology Advisory Committee Advances Report and Recommendations to the CFTC on Responsible Artificial Intelligence in Financial Markets. On May 2, the CFTC’s Technology Advisory Committee (TAC) released a Report on Responsible AI in Financial Markets. The CFTC stated that the TAC issued a Report that facilitates an understanding of the impact and implications of the evolution of AI on financial markets. The Committee made five recommendations to the Commission as to how the CFTC should approach this AI evolution to safeguard financial markets. The Committee urged the CFTC to leverage its role as a market regulator to support the current efforts on AI coming from the White House and Congress.]
CFTC Chairman Behnam Designates Ted Kaouk as the CFTC’s First Chief Artificial Intelligence Officer. On May 1, CFTC Chairman Rostin Behnam announced the designation of Dr. Ted Kaouk as the agency’s first Chief Artificial Intelligence Officer. Dr. Kaouk currently serves as the CFTC’s Chief Data Officer and Director of the Division of Data. The CFTC stated that in this newly expanded role as the CFTC’s Chief Data & Artificial Intelligence Officer, Dr. Kaouk will be responsible for leading the development of the CFTC’s enterprise data and artificial intelligence strategy to further integrate CFTC’s ongoing efforts to advance its data-driven capabilities.

New Developments Outside the U.S.

ESMA Publishes Data on Markets and Securities in the EEA. On May 16, ESMA published the Statistics on Securities and Markets (ESSM) Report, with the objective of increasing access to data of public interest. The report provides details about how securities markets in the European Economic Area (EEA30) were organized in 2022, including structural indicators on securities, markets, market participants and infrastructures. It covers the distribution of legal entities by member states, either based on their supervisory role or their location. It also contains information on third country entities when their activities are recognized (e.g., CCPs or benchmark administrators) or when their securities are traded in EEA30 (e.g., information on issuers and securities available for trading). [NEW]
ESMA to Host Web Event on Effective and Attractive Capital Markets. On May 22, ESMA will host an online event focused on the launch of its Position Paper on the effectiveness of capital markets in the European Union. Natasha Cazenave, ESMA Executive Director, will be moderating the event and Verena Ross, ESMA Chair, will present the paper and take questions from the audience. Registrations are now open. [NEW]
ESMA Guidelines Establish Harmonized Criteria for use of ESG and Sustainability Terms in Fund Names. On May 14, following the public statement of December 14, 2023, ESMA published the final report containing Guidelines on funds’ names using ESG or sustainability-related terms. The objective of the Guidelines is to ensure that investors are protected against unsubstantiated or exaggerated sustainability claims in fund names, and to provide asset managers with clear and measurable criteria to assess their ability to use ESG or sustainability-related terms in fund names. The Guidelines establish that to be able to use these terms, a minimum threshold of 80% of investments should be used to meet environmental, social characteristics or sustainable investment objectives. [NEW]
ESMA Asks for Input on Assets Eligible for UCITS. On May 7, ESMA published a Call for Evidence on the review of the Undertakings for Collective Investment in Transferable Securities (UCITS) Eligible Assets Directive (EAD). The objective of this call is to gather information from stakeholders to assess possible risk and benefits of UCITS gaining exposure to various asset classes. Investors and consumer groups interested in retail investment products, management companies of UCITS, self-managed UCITS investment companies, depositaries of UCITS and trade associations are invited to provide their feedback on market practices and interpretation or practical application issues with respect to the eligibility criteria and other provisions set out in the UCITS EAD.

New Industry-Led Developments

US Basel III Endgame: Trading and Capital Markets Impact. On May 16, in response to the US Basel III proposal, ISDA and the Securities Industry and Financial Markets Association (SIFMA) conducted a quantitative impact study (QIS) that showed that the market risk portion of the proposal, known as the Fundamental Review of the Trading Book, will result in a substantial increase in market risk capital of between 73% and 101%, depending on the extent to which banks use internal models. [NEW]
International Money Market Dates Market Practice Note. On May 15, ISDA published the International Money Market Dates Practice Note regarding setting the start date/effective date for over-the-counter interest rate derivatives traded by reference to an international money market date. [NEW]
ISDA Publishes DC Review and Launches Market Consultation. On May 13, ISDA published an independent review on the structure and governance of the Credit Derivatives Determinations Committees (DCs) and launched a market-wide consultation on its recommendations. The review covers the composition, functioning, governance, and membership of the DCs. The report makes several recommendations on possible changes that could be made to improve the structure of the DCs, which are now available on the ISDA website for public consultation. [NEW]
ISDA and FIA Response to CFTC on Swaps LTR Rules (Part 20). On May 13, ISDA and FIA responded to the CFTC’s proposed request for approval from the Office of Management and Budget to continue to collect information related to certain physical commodity swap positions in accordance with the CFTC’s swaps large trader reporting (LTR) rules. In the response, the associations request that the CFTC sunset the swaps LTR rules with §20.9 sunset provision. [NEW]
ISDA and IIF Response to CPMI-IOSCO on VM Practices. On May 10, ISDA and the Institute of International Finance (IIF) responded to a discussion paper on variation margin (VM) practices by the Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO). The associations are supportive of the effective practices on frequency, scheduling, and timing, pass through of VM, excess collateral and transparency from central counterparties (CCPs) to clearing members (CMs), which would foster market participants’ readiness for above-average VM calls. On effective practice 8 on transparency from CMs to clients on intraday VM calls, the response highlights that most CMs do not pass on intraday VM calls to their clients and this information would therefore not be relevant. [NEW]
ISDA and AFME Respond to FCA Publicizing Enforcement Consultation. On April 30, ISDA and the Association for Financial Markets in Europe (AFME) responded to a Financial Conduct Authority (FCA) proposal that would give it the ability to publicly name firms at the start of an investigation and before a decision has been reached on whether to take further action. According to ISDA, there has been a considerable reaction to the proposals across the financial services industry, and the response highlights various risks and concerns with the proposals, including the risk to the competitiveness of the UK, damage to shareholder value and reputation of the sector, and worse outcomes for consumers.
ISDA, SIFMA, and CCMA Publish T+1 Settlement Cycle Booklet. On April 30, ISDA, the Securities Industry and Financial Markets Association (SIFMA) and the Canadian Capital Markets Association (CCMA) published a T+1 settlement cycle booklet to address queries from market participants on the settlement cycle changes taking place in North America on May 27-28, 2024, and the possible impact to relevant securities and over-the-counter (OTC) derivatives transactions. This booklet may be updated from time to time.
ISDA Publishes Sub-Annex A Maintenance Guidelines for the 2005 ISDA Commodity Definitions. On April 30, ISDA published maintenance guidelines for Sub-Annex A of the 2005 ISDA Commodity Definitions. Sub-Annex A contains definitions for various Commodity Reference Prices.

The following Gibson Dunn attorneys assisted in preparing this update: Jeffrey Steiner, Adam Lapidus, Marc Aaron Takagaki, Hayden McGovern, and Karin Thrasher.

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 Derivatives practice group, or the following practice leaders and authors:

Jeffrey L. Steiner, Washington, D.C. (202.887.3632, jsteiner@gibsondunn.com)

Michael D. Bopp, Washington, D.C. (202.955.8256, mbopp@gibsondunn.com)

Michelle M. Kirschner, London (+44 (0)20 7071.4212, mkirschner@gibsondunn.com)

Darius Mehraban, New York (212.351.2428, dmehraban@gibsondunn.com)

Jason J. Cabral, New York (212.351.6267, jcabral@gibsondunn.com)

Adam Lapidus – New York (+1 212.351.3869, alapidus@gibsondunn.com)

Stephanie L. Brooker, Washington, D.C. (202.887.3502, sbrooker@gibsondunn.com)

William R. Hallatt, Hong Kong (+852 2214 3836, whallatt@gibsondunn.com)

David P. Burns, Washington, D.C. (202.887.3786, dburns@gibsondunn.com)

Marc Aaron Takagaki, New York (212.351.4028, mtakagaki@gibsondunn.com)

Hayden K. McGovern, Dallas (214.698.3142, hmcgovern@gibsondunn.com)

Karin Thrasher, Washington, D.C. (202.887.3712, kthrasher@gibsondunn.com)

Smith v. Spizzirri, No. 22-1218 – Decided May 16, 2024

Today, the Supreme Court held unanimously that the Federal Arbitration Act requires courts to stay, rather than dismiss, lawsuits in which all claims are subject to arbitration.

“When a federal court finds that a dispute is subject to arbitration, and a party has requested a stay of the court proceeding pending arbitration, the court does not have discretion to dismiss the suit on the basis that all the claims are subject to arbitration.”

Justice Sotomayor, writing for the Court

Background:

Section 3 of the Federal Arbitration Act (FAA) provides that when a dispute is subject to arbitration, the court “shall on application of one of the parties stay the trial of the action until such arbitration has been had in accordance with the terms of the agreement.” 9 U.S.C. § 3. A circuit split developed on whether the FAA permits a court to dismiss the lawsuit instead of issuing a stay when the dispute is subject to arbitration. Most circuits held that when the claims in a lawsuit are arbitrable and a party requests a stay pending arbitration, the FAA requires the court to stay the lawsuit. A minority of circuits held that courts have discretion to dismiss lawsuits in which the claims are arbitrable.

Smith and a group of current and former on-demand delivery drivers filed claims against Intelliserve LLC, a Phoenix-based delivery service, in federal court. Intelliserve moved to compel arbitration under its arbitration agreement with the drivers and requested a stay pending arbitration. The district court granted Intelliserve’s motion to compel arbitration and dismissed the case. The Ninth Circuit affirmed, holding that the district court properly exercised its discretion to dismiss the lawsuit.

Issue:

Does Section 3 of the FAA require courts to stay a lawsuit pending arbitration, or do courts have discretion to dismiss lawsuits in which the claims are subject to arbitration?

Court’s Holding:

When a court finds that a dispute is subject to arbitration and a party requests a stay pending arbitration, the court must stay the action and does not have discretion to dismiss the action.

What It Means:

The Court held that the plain text of Section 3 of the FAA “requires a court to stay the proceeding” and “overrides any discretion a district court might otherwise have had to dismiss a suit when the parties have agreed to arbitration.” Op. 4-5.
The Court’s decision means that parties opposing arbitration likely cannot immediately appeal orders compelling arbitration. If a court compelling arbitration were not required to issue a stay, and could instead dismiss the lawsuit, the party opposing arbitration could immediately appeal the dismissal of the lawsuit. By contrast, when a court compels arbitration and enters a stay, the party opposing arbitration ordinarily cannot appeal immediately. By requiring courts to stay lawsuits pending arbitration, the Court’s decision will likely prevent immediate appeals of orders compelling arbitration.
The Court reasoned that staying, rather than dismissing, lawsuits subject to arbitration comports with the supervisory role that the FAA envisions for courts, which include post-arbitration proceedings to confirm, vacate, or modify the arbitral award. A stay pending arbitration keeps the case on the court’s docket and allows parties to seek relief related to the arbitration without filing a new case.

The Court’s opinion is available here.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding developments at the U.S. Supreme Court. Please feel free to contact the following practice leaders:

Appellate and Constitutional Law Practice

Thomas H. Dupree Jr. +1 202.955.8547 tdupree@gibsondunn.com	Allyson N. Ho +1 214.698.3233 aho@gibsondunn.com	Julian W. Poon +1 213.229.7758 jpoon@gibsondunn.com
Lucas C. Townsend +1 202.887.3731 ltownsend@gibsondunn.com	Bradley J. Hamburger +1 213.229.7658 bhamburger@gibsondunn.com	Brad G. Hubbard +1 214.698.3326 bhubbard@gibsondunn.com

Related Practice: Class Actions

Christopher Chorba
+1 213.229.7396
cchorba@gibsondunn.com

Kahn A. Scolnick
+1 213.229.7656
kscolnick@gibsondunn.com

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CFPB v. Community Financial Services Association of America, No. 22-448 – Decided May 16, 2024

Today, the Supreme Court held 7-2 that the Consumer Financial Protection Bureau’s funding structure—which allows the agency to draw money from the Federal Reserve—does not violate the Constitution’s Appropriations Clause.

“Under the Appropriations Clause, an appropriation is simply a law that authorizes expenditures from a specified source of public money for designated purposes. The statute that provides the Bureau’s funding meets these requirements.”

Justice Thomas, writing for the Court

Background:

The Appropriations Clause states that “[n]o Money shall be drawn from the Treasury, but in Consequence of Appropriations made by law.” U.S. Const. art. I, § 9, cl. 7. When Congress created the Consumer Financial Protection Bureau (CFPB) in 2010, it determined that the CFPB would not receive its funding through an annual appropriation law, as most agencies do. Instead, it directed that the CFPB would receive funding directly from the Federal Reserve each year in an amount that the CFPB Director deems “reasonably necessary”—up to an inflation-adjusted cap. 12 U.S.C. § 5497(a)(1)–(2). The Federal Reserve, in turn, is also funded outside the ordinary appropriations process. 12 U.S.C. § 243.

Community Financial Services Association is an association of lenders that sought to set aside a CFPB regulation, arguing that it was promulgated through the CFPB’s use of funds received in violation of the Appropriations Clause. The Fifth Circuit agreed and vacated the regulation. It held that the CFPB’s funding structure violated the Appropriations Clause because the CFPB has unilateral discretion to determine its own funding level and the funds it receives are insulated from Congress’s control.

Issue:

Whether the CFPB’s funding structure violates the Constitution’s Appropriations Clause.

Court’s Holding:

The CFPB’s funding structure does not violate the Constitution’s Appropriations Clause.

What It Means:

Resolving the “narrow question” whether the CFPB’s funding mechanism complies with the Appropriations Clause, Justice Thomas, writing for a seven-Justice majority, held that the statute authorizing the CFPB’s funding qualifies as an “appropriation” because it specifies the amount (in the form of a cap), source, and purpose of the public funds. Op. 1, 15–16. The Court noted that unspecified but capped appropriations were commonplace after the founding. Op. 16. The Court held that it is not necessary that Congress regularly or directly appropriate public funds because the Constitution’s two-year limit for appropriations for the Army, U.S. Const. art. I, § 8, cl. 12, implies authority to make standing appropriations in other contexts, as confirmed by founding-era practice. Op. 17.
The Court did not agree that upholding the CFPB’s funding structure under the Appropriations Clause would allow the Executive to operate free of any meaningful fiscal check. Op. 18–19. While leaving open the possibility that there may be structural limits on agency funding mechanisms, the Court reasoned that those limits do not find their source in the Appropriations Clause. Id.
Justice Kagan, writing for four Justices, concurred to note that the CFPB’s funding scheme is consistent not only with founding-era practices, but also with practices “at any other time in our Nation’s history” up through the present day. Op. 1. Justice Jackson concurred separately, asserting that “[w]hen the Constitution’s text does not provide a limit to a coordinate branch’s power, we should not lightly assume that Article III implicitly directs the Judiciary to find one.” Op. 1.
Justice Alito, joined by Justice Gorsuch, dissented, concluding that “the CFPB’s unprecedented combination of funding features affords it the very kind of financial independence that the Appropriations Clause was designed to prevent.” Op. 23.
The decision rejects the constitutional challenge in this case and likely will allow CFPB actions stayed during the pendency of this case to resume. The Court’s “narrow” decision leaves open what constitutes “public money” or “designated purposes” for that money, questions that might be litigated in future cases involving other agencies’ funding schemes that do not depend on annual appropriations—such as the Federal Reserve, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Federal Housing Finance Agency. The decision also leaves open whether other structural limits may constrain an agency’s funding structure.

The Court’s opinion is available here.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding developments at the U.S. Supreme Court. Please feel free to contact the following practice leaders:

Appellate and Constitutional Law Practice

Thomas H. Dupree Jr. +1 202.955.8547 tdupree@gibsondunn.com	Allyson N. Ho +1 214.698.3233 aho@gibsondunn.com	Julian W. Poon +1 213.229.7758 jpoon@gibsondunn.com
Lucas C. Townsend +1 202.887.3731 ltownsend@gibsondunn.com	Bradley J. Hamburger +1 213.229.7658 bhamburger@gibsondunn.com	Brad G. Hubbard +1 214.698.3326 bhubbard@gibsondunn.com

Related Practice: Litigation

Reed Brodsky +1 212.351.5334 rbrodsky@gibsondunn.com	Trey Cox +1 214.698.3256 tcox@gibsondunn.com	Theane Evangelis +1 213.229.7726 tevangelis@gibsondunn.com
Helgi C. Walker +1 202.887.3599 hwalker@gibsondunn.com

Related Practice: Administrative Law and Regulatory Practice

Stuart F. Delery +1 202.955.8515 sdelery@gibsondunn.com	Eugene Scalia +1 202-955-8210 escalia@gibsondunn.com	Helgi C. Walker +1 202.887.3599 hwalker@gibsondunn.com
Russell Balikian +1 202.955.8535 rbalikian@gibsondunn.com

Gibson Dunn’s U.S. Supreme Court Round-Up provides summaries of cases decided during the October 2023 Term, a preview of cases set to be argued next Term, and highlights other key developments on the Court’s docket. During the October 2022 Term, the Court heard argument in 59 cases, released 58 opinions, and dismissed one case as improvidently granted. During the current Term, the Court heard 61 oral arguments and has released 20 opinions.

Spearheaded by Miguel Estrada, the U.S. Supreme Court Round-Up keeps clients apprised of the Court’s most recent actions. The Round-Up previews cases scheduled for argument, tracks the actions of the Office of the Solicitor General, and recaps recent opinions. The Round-Up provides a concise, substantive analysis of the Court’s actions. Its easy-to-use format allows the reader to identify what is on the Court’s docket at any given time, and to see what issues the Court will be taking up next. The Round-Up is the ideal resource for busy practitioners seeking an in-depth, timely, and objective report on the Court’s actions.

View the Round-Up here.

Gibson Dunn has a longstanding, high-profile presence before the Supreme Court of the United States, appearing numerous times in the past decade in a variety of cases. Fifteen current Gibson Dunn lawyers have argued before the Supreme Court, and during the Court’s eight most recent Terms, the firm has argued a total of 21 cases, including closely watched cases with far-reaching significance in the areas of intellectual property, securities, separation of powers, and federalism. Moreover, although the grant rate for petitions for certiorari is below 1%, Gibson Dunn’s petitions have captured the Court’s attention: Gibson Dunn has persuaded the Court to grant 36 petitions for certiorari since 2006.

* * * *

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding developments at the U.S. Supreme Court. Please feel free to contact the following attorneys, or any member of the Appellate and Constitutional Law Practice Group.

Thomas H. Dupree Jr. (+1 202.955.8547, tdupree@gibsondunn.com)
Allyson N. Ho (+1 214.698.3233, aho@gibsondunn.com)
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This action highlights the need for investment advisers to exercise caution when contemplating any situation in which legal fees will be shared with clients.

On April 29, 2024, the Securities and Exchange Commission (the “SEC” or the “Commission”) entered an administrative cease and desist order (the “Order”) against a registered investment adviser (the “Adviser”)[1] finding that the adviser had an “impermissible joint legal fee arrangement” with its client, Mutual Fund Series Trust (“Trust”), an SEC-registered open-end investment company.[2] This action highlights the need for investment advisers to exercise caution when contemplating any situation in which legal fees will be shared with clients.

Joint Legal Fee Arrangement

The Order states that the Adviser advised a series of the Trust that “experienced significant losses from its options-trading investment strategy.” Inquiries from regulators and private lawsuits soon followed, and the Adviser and the Trust retained the same counsel to represent them; neither the joint engagement letter nor the invoices explained “how legal fees and other expenses would be allocated between the Adviser and the Trust.”[3]

Because the Trust was insured for legal expenses and the Adviser was not, the Adviser “arranged to have all of the legal bills” from the joint engagement “paid by the Trust and subsequently submitted to the Trust’s insurer” to maximize insurance coverage. According to the Order, the Adviser said it intended to reimburse the Trust for any amounts not covered by insurance. Notably, the Adviser and the Trust entered this joint legal fee arrangement “without knowledge or approval of the independent trustees of the Trust’s Board of Trustees (‘Board’) and without making an application to the Commission . . . pursuant to Rule 17d-1 under the Investment Company Act.”[4]

From May 2017 to March 2020, the Trust paid nearly $2.5 million in legal fees and costs relating to the joint representation. The Adviser paid nothing during this period.[5] In April 2020, almost three full years after the Trust’s first payment, the Adviser contributed by paying $781,250 of the Trust’s share of a legal settlement in one of the private lawsuits. For the remainder of 2020 the Trust continued to pay nearly 80% of new legal fees incurred while the Adviser paid the other 20%.[6]

The SEC contacted the Adviser in early 2021 about the joint arrangement, and afterwards, the Trust, “in consultation with Counsel and independent trustees’ counsel,” allocated $1,277,388 of the legal fees to the Adviser. After accounting for the $781,250 already paid, the Adviser paid the remaining $472,403 to the Trust and, at the Board’s request, an additional $30,726 in interest.[7] The Trust’s insurer subsequently determined that it would cover “$183,757 less than the amount the Adviser and the Trust had agreed would be allocated to the Trust.” In connection with efforts to resolve the SEC’s investigation, “[the Adviser] voluntarily repaid the Trust $183,757 for those legal expenses.”[8]

Violations and Penalties

The SEC found that the Adviser’s joint legal fee arrangement violated “Section 17(d) of the Investment Company Act and Rule 17d-1 thereunder, which generally prohibit any affiliated person of a registered investment company, acting as principal, from participating in . . . any . . . joint arrangement . . . in which such registered investment company is a participant, absent an order issued by the Commission.”[9] It also found that the Adviser violated “Section 206(2) of the Advisers Act, which makes it unlawful for any investment adviser . . . to engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client.”[10] The adviser settled the matter without admitting or denying the SEC’s findings.

As part of its settlement, the Adviser was ordered to pay disgorgement of $280,902 (which included “time value of money benefit” and an “offset” of $183,757 based on the Adviser’s last payment to the Trust), prejudgment interest of $30,081, and a civil penalty of $200,000 to the SEC.

Analysis & Key Takeaways

Investment advisers should exercise caution before entering into joint legal fee arrangements with clients.

If considering joint representation with a client, investment advisers should ensure that legal fees and other expenses are invoiced separately from the outset of the arrangement and should ensure that the allocation of expenses is approved by any independent board or other necessary decisionmakers of the client.

Registered investment companies must seek an order from the SEC pursuant to Rule 17-d under the Investment Company Act before entering any into joint legal fee arrangements with clients.

Investment advisers should not defer any share of their legal expenses to the client. Instead, investment advisers should pay expenses as they are incurred.

Conclusion

The SEC’s settlement highlights the risks associated with joint legal fee arrangements with clients. The SEC will closely scrutinize such arrangements and, even when the investment adviser pays its full share of legal expenses, may still take enforcement action for delaying the proper allocation, approval, or payment of expenses, or for failing to seek an order from the SEC pursuant to Rule 17-d of the Investment Company Act.

__________

[1] Order Instituting Administrative and Cease-and-Desist Proceedings, Pursuant to Sections 203(e) and 203(k) of the Investment Advisers Act of 1940 and Sections 9(b) and 9(f) of the Investment Company Act of 1940, Making Findings, and Imposing Remedial Sanctions and a Cease-and-Desist Order, Release No. 6597 (April 29, 2024).

[2] Id., Paragraph 1.

[3] Id., Paragraph 4.

[4] Id., Paragraph 5.

[5] Id., Paragraph 6.

[6] Id., Paragraph 8.

[7] Id., Paragraph 9.

[8] Id., Paragraph 10.

[9] Id., Paragraph 11.

[10] Id., Paragraph 12.

The following Gibson Dunn lawyers assisted in preparing this update: Lauren Jackson, Tina Samanta, David Woodcock, and Brian Clegg.

Gibson Dunn’s lawyers are available to assist with any questions you may have regarding the issues and considerations discussed above. Please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any leader or member of the firm’s Securities Enforcement or Investment Funds practice groups:

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A recent proposed rule from the U.S. Department of the Treasury aims to enhance CFIUS’s ability to request information from parties, increase potential penalty amounts, and expedite mitigation agreement negotiations. Similarly, a new GAO study reveals CFIUS’s enforcement priorities and increasing reliance on mitigation agreements to address national security concerns.

On April 11, 2024, the U.S. Department of the Treasury (“Treasury”), as Chair of the Committee on Foreign Investment in the United States (“CFIUS” or “the Committee”) issued a Notice of Proposed Rulemaking (the “Proposed Rule”) that proposes to expand the types of information CFIUS may request in the course of non-notified reviews, add a time limit for parties to respond to mitigation agreement drafts, and raise the maximum penalty amount that Committee may impose for CFIUS violations (including violations of mitigation agreements), among other changes.

Shortly thereafter, the U.S. Government Accountability Office (“GAO”) publicly released a report outlining its findings concerning the Committee’s use of mitigation agreements, coordination of enforcement decisions, and staffing resources, along with recommendations for certain enhancements.

Together, the Proposed Rule and the GAO report underscore the increasing prominence of CFIUS and signal an expansion of the Committee’s monitoring and enforcement capabilities. We summarize key aspects of both below.

Proposed Rule to Expand CFIUS’s Monitoring and Enforcement Capabilities

Expanded Scope of Information Requested in Non-Notified Reviews

The Proposed Rule would expand the types of information that CFIUS can require transaction parties and other persons to submit. Current regulations permit CFIUS to request parties provide information necessary for the Committee to determine if a non-notified transaction constitutes a “covered transaction” under Part 800 or a “covered real estate transaction” under Part 802 of the CFIUS regulations. The Proposed Rule would authorize the Committee to issue requests more broadly to transaction parties and other persons for information to determine if a transaction (i) meets the criteria for a mandatory declaration and/or (ii) raises national security concerns. This expanded scope of information requests would, according to CFIUS, enhance the Committee’s ability to engage in preliminary fact-finding and further help determine whether to request transaction parties submit a declaration or notice for review.

Increased Obligations to Provide Additional Information Related to Compliance Monitoring

The Proposed Rule also expands CFIUS’s ability to require parties to provide information to the Committee in two situations post-CFIUS review:

Monitoring Compliance: Situations in which the Committee requires information to monitor compliance with or enforce the terms of a mitigation agreement, order, or condition; and
Material Misstatements or Omissions: Situations in which the Committee seeks information to ascertain whether the transaction parties have made a material misstatement or omitted crucial information during the CFIUS’s review or investigation.

While such information is already routinely requested by the Committee, the Proposed Rule formalizes the current practice and explicitly obligates parties to respond. Additionally, the Proposed Rule changes the condition for the Committee to request such information from “[i]f deemed necessary by the Committee” to “[i]f deemed appropriate by the Committee,” thereby lowering the threshold for such information requests. As with the current rule, a subpoena may be issued to non-compliant parties, but the Proposed Rule specifically assigns this power to the Staff Chairperson (as opposed to the Committee as a whole) to increase operational efficiency.

Specific Timelines for Risk Mitigation Negotiations

As discussed at greater length below, in recent years, CFIUS has increasingly imposed mitigation agreements on transaction parties in order to address alleged national security concerns. While the current regulations require parties to respond to follow-up information requests from CFIUS within three business days during the course of a transaction review, the regulations are silent on the timeframe within which parties must respond to mitigation proposals or revisions, including in the context of non-notified reviews. The Proposed Rule recognizes that in some cases, particularly in situations where transactions have already closed, parties are less motivated to respond in a timely manner without a clear obligation. Accordingly, the Proposed Rule creates a similar deadline of three business days for parties to provide substantive responses to proposed mitigation terms, though, as with responses to follow-up information requests, the CFIUS Staff Chairperson may grant reasonable extensions on a case-by-case basis. Substantive responses include acceptance of terms as proposed, counterproposals, or a detailed statement of reasons explaining why a party or parties cannot comply with the terms as proposed (which may also include a counterproposal). If parties fail to respond within the prescribed timeframe, the Committee may reject the notice or declaration.

Increased Maximum Civil Monetary Penalties

The Proposed Rule notes a significant drop in the median value of covered transactions filed with CFIUS pursuant to a joint voluntary notice following the implementation of the Foreign Investment Risk Review Modernization Act of 2018 and the introduction of mandatory declarations. According to the Committee, the relatively low value of many transactions undermines the current penalty framework of imposing fines of up to greater of $250,000 or the value of the transaction. For example, for certain transactions with reported low values (or even a valuation of zero dollars), the maximum penalty de facto becomes $250,000, which the Committee considers an insufficient deterrent in many instances. Consequently, the Proposed Rule would, for the first time in 15 years, increase and expand the maximum civil penalties as follows:

Material Misstatements and Omissions in Submissions. The maximum civil monetary penalty for a declaration or notice with a material misstatement or omission, or a false certification, would be increased from $250,000 to $5,000,000 per violation.
Expansion of Material Misstatements and Omissions Penalty to Information Request Responses. Currently, the above penalty only applies to material misstatements or omissions in the context of a declaration or notice filed with CFIUS, or a false certification. The Proposed Rule would expand penalty coverage to (1) requests for information related to non-notified transactions, (2) certain responses to the Committee’s requests for information related to monitoring or enforcing compliance, and (3) other responses to the Committee’s requests for information, such as for agency notices. While this expanded coverage is significant, CFIUS makes clear that the penalty provisions would not apply to the majority of communications with the Committee; rather, only with respect to responses to requests that were made in writing by the Committee, specified a time frame for response, and indicated the applicability of penalty provisions.
Failure to Submit Mandatory Declarations. The maximum civil monetary penalty for failure to submit a mandatory declaration would be increased from the greater of $250,000 or the value of the transaction to the greater of $5,000,000 or the value of the transaction.
Material Mitigation Agreement Violations. The maximum civil monetary penalty for the violation of a mitigation agreement, intentionally or through gross diligence, would be increased from the greater of $250,000 per violation or the value of the transaction to the greater of $5,000,000 per violation or the value of the transaction. Further, the transaction value would be revised to include the greater of (i) the value of the person’s interest in the U.S. business (or, as applicable, the parent of the U.S. business) at the time of the transaction; (ii) the value of the person’s interest in the U.S. business (or, as applicable, the parent of the U.S. business) at the time of the violation in question or the most proximate time to the violation for which assessing such value is practicable; or (ii) the value of the transaction filed with the Committee. This expanded approach to transaction value would allow CFIUS greater latitude in imposing penalties, though CFIUS makes clear it would only apply to mitigation agreements entered into, conditions imposed, or orders issued on or after the effective date of the final rule.
Extension of Penalty Petition Timeframe from 15 to 20 Days. Currently, parties have up to 15 business days to submit a petition to the Committee in response to a penalty notice, and the Committee similarly has 15 business days to respond. Under the Proposed Rule, both timeframes would be extended to 20 business days to account for the Committee’s routine practice of granting extensions for such petitions.

Written comments to the Proposed Rule must be received by Wednesday, May 15, 2024, by mail or submitted electronically at Regulations.gov. After such comments are received and reviewed, Treasury is expected to issue a final rule in short order.

GAO Report Provides Insight into CFIUS Mitigation Agreements and Makes Related Recommendations to Standardize Certain Processes

On April 18, 2024, GAO publicly released a report evaluating issues related to CFIUS mitigation agreements and staffing and offered targeted recommendations for improvement.

First, GAO recommended two changes related to CFIUS’s process for handling mitigation agreements:

The Secretary of the Treasury, as CFIUS’s chair, should work with member agencies to document a committee-wide process for considering and making timely decisions on enforcement actions related to mitigation agreements.
The Secretary of the Treasury, as CFIUS’s chair, should work with member agencies to document a committee-wide process for periodically assessing the relevance of mitigation agreements and amending, phasing out, or terminating them when appropriate.

Second, GAO recommends CFIUS take three actions to evaluate the level of staffing devoted to mitigation agreements:

The Secretary of the Treasury should document Treasury’s objectives for increasing its staff for monitoring and enforcing compliance with CFIUS mitigation agreements.
The Secretary of the Treasury should, once the targeted staffing increase is completed, analyze its CFIUS monitoring and enforcement staffing in accordance with federal workforce planning guidance, to determine the extent to which the targeted increase enables Treasury to achieve its documented objectives.
The Secretary of the Treasury, as CFIUS’s chair, should work with member agencies to establish a committee-wide process to regularly discuss and coordinate the staffing levels needed to address the projected increase in workload associated with monitoring and enforcing CFIUS mitigation agreements.

Apart from these recommendations, the GAO report provides key insights into CFIUS’s use of mitigation agreements and the Committee’s enforcement priorities, including the following:

Increasing Use of Mitigation Agreements and Focus on Agreement Monitoring
- From December 2000 through December 2022, the GAO reports that the cumulative total number of active mitigation agreements increased significantly, from about five to almost 230, with the number almost quadrupling from December 2012 to December 2022.
- The U.S. Department of Defense (“DOD”) has played an increasing role in supervising mitigation agreements, including an increased focus on risks related to supply assurance (which were addressed in almost half of the mitigation agreements DOD was monitoring at the end of 2022).
Increased Coordination Among CFIUS Agencies and Departments Needed, Especially with Respect to Mitigation Agreement Procedures
- The lack of clear standards to justify terminating mitigation agreements has led to long delays in the process, and GAO recommends CFIUS implement clearer responsibilities and written guidance for termination decisions.
- Treasury is working with other CFIUS agencies and departments to harmonize monitoring compliance with mitigation agreements, standardize tracking and reporting violations, and bolster enforcement resources.
Focus Is on Enforcement and Imposing Penalties When Determined Necessary
- As of October 2023, CFIUS had publicly reported only two penalties, though additional non-public penalties were imposed in 2023 and others were not yet finalized at the time the GAO report was published. The two public penalties were as follows:
  - In 2018, CFIUS imposed a $1 million penalty for repeated breaches of a 2016 mitigation agreement, including failure to establish required security policies and failure to provide adequate reports to the committee.
  - In 2019, CFIUS imposed a $750,000 penalty for violations of a 2018 interim order, including failure to restrict and adequately monitor access to protected data.
- The majority of violations identified by CFIUS have been minor or technical in nature, though CFIUS intends to increase its focus on enforcement in the coming months.
- Treasury intends to roughly double the number of Treasury staff dedicated to CFIUS monitoring and enforcement by the end of fiscal year 2024.
Site Visits to Monitor Mitigation Efforts May Become More Common
- While site visits currently occur about once every 3 years for many mitigation agreements—due primarily to the lack of resources and large number of active mitigation agreements—several CFIUS officials recognized such site visits as a critical tool for monitoring compliance, signaling their frequency may increase in the near future.

Both the Proposed Rule and the findings in the GAO report exemplify the increasingly robust role CFIUS plays in aggressively monitoring and shaping foreign direct investment in the United States. In light of these efforts and the increasing costs of non-compliance, transaction parties should carefully evaluate transactions involving foreign person investors, directly or indirectly, for CFIUS risks even in the early stages of deal discussions. CFIUS’s role and impact are poised only to increase as Treasury finalizes the Proposed Rule and the Committee ramps up its enforcement efforts.

The following Gibson Dunn lawyers prepared this update: Stephenie Gosnell Handler, Mason Gauch, and Chris Mullen.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these issues. For additional information about how we may assist you, please contact the Gibson Dunn lawyer with whom you usually work, the authors, or the following leaders and members of the firm’s International Trade practice group:

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From the Derivatives Practice Group: This week, ESMA has issued a Call for Evidence to gather information from stakeholders to assess the risks and benefits of the Undertakings for Collective Investment in Transferable Securities gaining exposure to various asset classes.

New Developments

Statement of Chairman Rostin Behnam Regarding Proposed Event Contracts Rulemaking. On May 10, CFTC Chairman Rostin Behnam remarked on his support for the proposed amendments to the Commission’s rules concerning event contracts. The Chairman remarked that the Commission proposes to further specify the types of event contracts that fall within the scope of CEA section 5c(c)(5)(C) and are contrary to the public interest. He believes that the amendments will support efforts by registered entities to comply with the CEA by more clearly identifying the types of event contracts that may not be listed for trading or accepted for clearing. [NEW]
CFTC Technology Advisory Committee Advances Report and Recommendations to the CFTC on Responsible Artificial Intelligence in Financial Markets. On May 2, the CFTC’s Technology Advisory Committee (TAC) released a Report on Responsible AI in Financial Markets. The CFTC stated that the TAC issued a Report that facilitates an understanding of the impact and implications of the evolution of AI on financial markets. The Committee made five recommendations to the Commission as to how the CFTC should approach this AI evolution to safeguard financial markets. The Committee urged the CFTC to leverage its role as a market regulator to support the current efforts on AI coming from the White House and Congress. [NEW]
CFTC Chairman Behnam Designates Ted Kaouk as the CFTC’s First Chief Artificial Intelligence Officer. On May 1, CFTC Chairman Rostin Behnam announced the designation of Dr. Ted Kaouk as the agency’s first Chief Artificial Intelligence Officer. Dr. Kaouk currently serves as the CFTC’s Chief Data Officer and Director of the Division of Data. The CFTC stated that in this newly expanded role as the CFTC’s Chief Data & Artificial Intelligence Officer, Dr. Kaouk will be responsible for leading the development of the CFTC’s enterprise data and artificial intelligence strategy to further integrate CFTC’s ongoing efforts to advance its data-driven capabilities.
CFTC Approves Final Rule Amending the Capital and Financial Reporting Requirements of Swap Dealers and Major Swap Participants. On April 30, the CFTC announced it has approved a final rule that amends the capital and financial reporting requirements of Swap Dealers (SDs) and Major Swap Participants (MSPs). According to the CFTC, the amendments make changes consistent with CFTC Staff Letter No. 21-15 regarding the tangible net worth capital approach for calculating capital under CFTC Regulation 23.101, as well as CFTC Staff Letter No. 21-18, as further extended by CFTC Staff Letter No. 23-11, regarding the alternate financial reporting requirements for SDs subject to the capital requirements of a prudential regulator. The amendments also revise certain Part 23 regulations regarding the financial reporting requirements of SDs, including the required timing of certain notifications, the process for approval of subordinated debt for capital, and the information requested on financial reporting forms to conform to the rules. The CFTC stated that the amendments are intended to make it easier for SDs and MSPs to comply with the CFTC’s financial reporting obligations and demonstrate compliance with minimum capital requirements. To allow for sufficient time to effectuate the reporting and notification amendments, the final rule has a compliance date of September 30, 2024, and will apply to all financial reports with an “as of” reporting date of September 30, 2024, or later.
CFTC Approves Final Rules on Large Trader Reporting for Futures and Options. On April 30, the CFTC announced approval of final rules to amend its large trading reporting regulations for futures and options. These regulations require futures commission merchants, clearing members, foreign brokers, and certain reporting markets (reporting firms) to report to the Commission position information for the largest futures and options traders. The final rules replace the data elements currently enumerated in the CFTC’s regulations with an appendix specifying applicable data elements. The final rules also provide for the publication of a separate Part 17 Guidebook specifying the form and manner for reporting. In addition, the final rules remove the outdated 80-character data submission standard in the CFTC’s regulations. According to the CFTC, that standard will be replaced by a FIXML standard, as set out in the Part 17 Guidebook.
CFTC Approves Final Rules on Swap Confirmation Requirements for SEFs. On April 23, the CFTC approved final rules to amend its swap execution facility (SEF) regulations related to uncleared swap confirmations to address issues which have been addressed in CFTC staff no-action letters, including the most recent CFTC No Action Letter No. 17-17, as well as associated conforming and technical changes. In particular, the final rules amend CFTC Regulation 37.6(b) to enable SEFs to incorporate terms of underlying, previously negotiated agreements between the counterparties by reference in an uncleared swap confirmation without being required to obtain such underlying, previously negotiated agreements. Further, the final rules amend CFTC Regulation 37.6(b) to require such confirmation to take place “as soon as technologically practicable” after the execution of the swap transaction on the SEF for both cleared and uncleared swap transactions. The final rules also amend CFTC Regulation 37.6(b) to make clear the SEF-provided confirmation under CFTC Regulation 37.6(b) shall legally supersede any conflicting terms in a previous agreement, rather than the entire agreement. The final rules make conforming amendments to CFTC Regulation 23.501(a)(4)(i) to correspond with the amendments to CFTC Regulation 37.6(b). Finally, the final rules make certain non-substantive amendments to CFTC Regulation 37.6(a)-(b) to enhance clarity.
CFTC Extends Public Comment Period for Proposed Rule for Designated Contract Markets and Swap Execution Facilities Regarding Governance and Conflicts of Interest. On April 22, the CFTC announced it is extending the deadline for public comment period on a proposed rule that makes certain modifications to rules for Swap Execution Facilities and Designated Contract Markets in Part 37 and 38 that would establish governance requirements regarding market regulation functions, as well as related conflicts of interest standards. The deadline is being extended to May 13, 2024.

New Developments Outside the U.S.

ESMA Asks for Input on Assets Eligible for UCITS. On May 7, ESMA published a Call for Evidence on the review of the Undertakings for Collective Investment in Transferable Securities (UCITS) Eligible Assets Directive (EAD). The objective of this call is to gather information from stakeholders to assess possible risk and benefits of UCITS gaining exposure to various asset classes. Investors and consumer groups interested in retail investment products, management companies of UCITS, self-managed UCITS investment companies, depositaries of UCITS and trade associations are invited to provide their feedback on market practices and interpretation or practical application issues with respect to the eligibility criteria and other provisions set out in the UCITS EAD. [NEW]
ESMA Publishes the Annual Transparency Calculations for Non-Equity Instruments, Bond Liquidity Data and Quarterly SI Calculations. On April 30, ESMA published the results of the annual transparency calculations for non-equity instruments, new quarterly liquidity assessment of bonds and the quarterly systematic internaliser calculations under MiFID II and MiFIR. As indicated in ESMA’s public statement on March 27, the quarterly liquidity assessment of bonds as well as the data for the quarterly systematic internalizers will continue to be published by ESMA.
ESAs Issue Spring 2024 Joint Committee Update. On April 30, the three European Supervisory Authorities (EBA, EIOPA and ESMA – the ESAs) issued their Spring 2024 Joint Committee update on risks and vulnerabilities in the EU financial system. The risk update shows that risks remain elevated in a context of slowing growth, an uncertain interest rate environment and ongoing geopolitical tensions. According to the update, in recent months, financial markets have performed strongly in anticipation of potential interest rate cuts in 2024 in both the EU and the US, despite the significant uncertainty surrounding these. The ESAs stated that this strong performance entails elevated risks of market corrections linked to unexpected events.

New Industry-Led Developments

ISDA and AFME Respond to FCA Publicizing Enforcement Consultation. On April 30, ISDA and the Association for Financial Markets in Europe (AFME) responded to a Financial Conduct Authority (FCA) proposal that would give it the ability to publicly name firms at the start of an investigation and before a decision has been reached on whether to take further action. According to ISDA, there has been a considerable reaction to the proposals across the financial services industry, and the response highlights various risks and concerns with the proposals, including the risk to the competitiveness of the UK, damage to shareholder value and reputation of the sector, and worse outcomes for consumers. [NEW]
ISDA Launches Outreach Initiative on Proposed Notices Hub. On April 25, ISDA announced major industry outreach initiative to establish support among dealers and buy-side firms for a new online platform that would allow the instantaneous delivery and receipt of critical termination-related notices, reducing the risk exposure and potential losses from a delay. Under the ISDA Master Agreement, termination-related notices must be delivered by certain prescribed methods, using company address details listed in the agreement. However, delays can occur if a company has moved and the documentation hasn’t been updated with the new details or if delivery to a physical location is not possible due to geopolitical shocks. The proposed ISDA Notices Hub would act as a secure central platform for firms to deliver notices, with automatic alerts sent to the receiving entity. Multiple designated people at each firm would be able to access the hub from anywhere in the world, regardless of the situation at its physical location. The platform would also allow market participants to update their physical address details via a single entry, providing a golden source of those details.
ISDA, SIFMA, and CCMA Publish T+1 Settlement Cycle Booklet. On April 30, ISDA, the Securities Industry and Financial Markets Association (SIFMA) and the Canadian Capital Markets Association (CCMA) published a T+1 settlement cycle booklet to address queries from market participants on the settlement cycle changes taking place in North America on May 27-28, 2024, and the possible impact to relevant securities and over-the-counter (OTC) derivatives transactions. This booklet may be updated from time to time.
ISDA Publishes Sub-Annex A Maintenance Guidelines for the 2005 ISDA Commodity Definitions. On April 30, ISDA published maintenance guidelines for Sub-Annex A of the 2005 ISDA Commodity Definitions. Sub-Annex A contains definitions for various Commodity Reference Prices.
ISDA and SIFMA Submit Addendum to Proposed FFIEC Reporting Revisions. On April 23, ISDA and the Securities Industry and Financial Markets Association (SIFMA) submitted an addendum to the joint response to the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency on the proposed reporting revisions of the call report, FFIEC 101 and FFIEC 102, which are designed to reflect the implementation of the Basel III endgame proposal. The addendum contains additional findings in the FFIEC 102 report, including end-of-week Fundamental Review of the Trading Book standardized approach average calculations and reported market risk risk-weighted assets in sub-parts D and E.

The following Gibson Dunn attorneys assisted in preparing this update: Jeffrey Steiner, Adam Lapidus, Marc Aaron Takagaki, Hayden McGovern, and Karin Thrasher.

Jeffrey L. Steiner, Washington, D.C. (202.887.3632, jsteiner@gibsondunn.com)

Michael D. Bopp, Washington, D.C. (202.955.8256, mbopp@gibsondunn.com)

Michelle M. Kirschner, London (+44 (0)20 7071.4212, mkirschner@gibsondunn.com)

Darius Mehraban, New York (212.351.2428, dmehraban@gibsondunn.com)

Jason J. Cabral, New York (212.351.6267, jcabral@gibsondunn.com)

Adam Lapidus – New York (+1 212.351.3869, alapidus@gibsondunn.com)

Stephanie L. Brooker, Washington, D.C. (202.887.3502, sbrooker@gibsondunn.com)

Roscoe Jones Jr., Washington, D.C. (202.887.3530, rjones@gibsondunn.com)

William R. Hallatt, Hong Kong (+852 2214 3836, whallatt@gibsondunn.com)

David P. Burns, Washington, D.C. (202.887.3786, dburns@gibsondunn.com)

Marc Aaron Takagaki, New York (212.351.4028, mtakagaki@gibsondunn.com)

Hayden K. McGovern, Dallas (214.698.3142, hmcgovern@gibsondunn.com)

Karin Thrasher, Washington, D.C. (202.887.3712, kthrasher@gibsondunn.com)

This edition of Gibson Dunn’s Federal Circuit Update for April 2024 summarizes the current status of several petitions pending before the Supreme Court, and recent Federal Circuit decisions concerning patent eligibility under 35 U.S.C. § 101, obviousness, and unenforceability due to inequitable conduct and unclean hands.

Federal Circuit News

Noteworthy Petitions for a Writ of Certiorari:

There were no new potentially impactful petitions filed before the Supreme Court in April 2024. We provide an update below of the petitions pending before the Supreme Court that were summarized in our March 2024 update:

The petitions in Vanda Pharmaceuticals Inc. v. Teva Pharmaceuticals USA, Inc. (US No. 23-768) and Ficep Corp. v. Peddinghaus Corp. (US No. 23-796) were denied.

Upcoming Oral Argument Calendar

The list of upcoming arguments at the Federal Circuit is available on the court’s website.

Key Case Summaries (April 2024)

AI Visualize, Inc. v. Nuance Communications, Inc., No. 22-2109 (Fed. Cir. Apr. 4, 2024): AI Visualize asserted four related patents in the field of visualization of medical scans. Specifically, the patents disclose using two-dimensional MRI scans to present three-dimensional views that can lead to better diagnosis and prognosis. The district court granted a motion to dismiss under Rule 12(b)(6), determining that the asserted claims were directed to patent-ineligible subject matter under 35 U.S.C. § 101.

The Federal Circuit (Reyna, J., joined by Moore, C.J., and Hughes, J.) affirmed, holding that the claims were direct to patent-ineligible subject matter. At step one, “the asserted claims are directed to converting data and using computers to collect, manipulate, and display the data” and “the steps of obtaining, manipulating, and displaying data, particularly when claimed at a high level of generality, are abstract concepts.” At step two, the Court agreed with the district court that “the asserted claims involved nothing more than the abstract idea itself” and conventional computer technology. AI argued that creation of virtual views significantly transforms the claims into patent-eligible subject matter; however, the Court determined that the specification conceded that this was known in the art, which AI also acknowledged at oral argument.

Salix Pharmaceuticals, Ltd. v. Norwich Pharmaceuticals Inc., No. 22-2153 (Fed. Cir. Apr. 11, 2024): Norwich filed an ANDA seeking to market 550 mg tablets of a generic version of rifaximin to treat hepatic encephalopathy (“HE”) and irritable bowel syndrome with diarrhea (“IBS-D”). Salix, which sells rifaximin under the name Xifaxan® for the treatment of HE and IBS-D, sued Norwich for infringement. The district court held that (1) Norwich infringed Salix’s patents directed to the use of rifaximin for treating HE, and (2) Norwich infringed Salix’s patents directed to the use of rifaximin for treating IBS-D, but that those claims would have been obvious over certain prior art. Norwich then amended its ANDA to remove the infringing HE indication, and moved to modify the judgment under Rule 60(b) asserting that the amendment negated any possible infringement, but the district court denied this motion.

The majority (Lourie, J., joined by Chen, J.) affirmed. The majority first affirmed the district court’s holding that the asserted claims of the IBS-D patents were invalid as obvious. Salix’s patents are directed to treating IBS-D with 550 mg of rifaximin three times a day. One prior art reference had a study evaluating 550 mg doses twice a day, and a second prior art reference teaches administering 400 mg three times a day and further states that “[r]ecent data suggest that the optimal dosage of rifaximin may, in fact, be higher.” Based on the combination of these references, the majority determined that there was no clear error in the conclusion that a skilled artisan would have had a reasonable expectation of success in the claimed dosage. A skilled artisan would have discerned from the combination that the optimal dosage for treating patients suffering from IBS-D may be higher than 400 mg three times a day, and the next higher dosage unit from the clinical trial was 550 mg. The majority also concluded that the district court did not abuse its discretion in refusing to modify the judgment under Rule 60(b), because considering the amended ANDA, which removed the infringing HE indication, would “essentially be a second litigation.”

Judge Cunningham dissented-in-part, writing that she would have instead vacated the district court’s conclusion that the asserted claims of the IBS-D patents are invalid as obvious. Specifically, she concluded that the prior art references’ lack of discussion of the claimed dosage would mean that a skilled artisan would not have had a reasonable expectation of success for the claimed dosage. In particular, Judge Cunningham disagreed with the majority’s reliance on the prior art reference’s statement that “[r]ecent data suggest that the optimal dosage of rifaximin may, in fact, be higher” because that statement does not discuss an actual optimal dosage and uses the word “may.”

Luv N’ Care, Ltd. v. Laurain, Nos. 22-1905, 22-1970 (Fed. Cir. Apr. 12, 2024): Laurain (the inventor) and Eazy-PZ (“EZPZ”) alleged that Luv n’ care, Ltd. (“LNC”) infringed EZPZ’s patent directed to toddler dining mats. LNC asserted defenses of inequitable conduct and unclean hands. The district court concluded that LNC had failed to prove that the patent was unenforceable due to inequitable conduct. Although Laurain and patent prosecution counsel had made a misrepresentation to the Patent and Trademark Office (“PTO”), the district court found the misrepresentation was not but-for material to the patentability of the asserted patent. The district court, however, concluded EZPZ’s litigation conduct did amount to unclean hands, including by failing to disclose certain patent applications during discovery and attempting repeatedly to block LNC from obtaining Laurain’s prior art searches.

The Federal Circuit (Stark, J., joined by Reyna and Hughes, JJ.) affirmed-in-part, vacated-in-part, and remanded. The Court affirmed the ruling of unclean hands finding the district court did not clearly err in its determination that EZPZ’s litigation conduct, including its failure to disclose related patent applications amounted to unclean hands. For inequitable conduct, which requires showing the patentee (1) withheld information from the PTO, and (2) did so with specific intent to deceive the PTO, the Court vacated the district court’s judgment and found that the district court failed to make separate findings as to materiality and deceptive intent. Additionally, regarding materiality, the Court remanded for the district court to determine whether Laurain’s misrepresentation to the PTO amounted to “affirmative egregious misconduct” that would establish per se materiality. Regarding deceptive intent, the Court determined that the district court erred in considering the “individual acts of misconduct in isolation and failed to address the collective weight of the evidence regarding each person’s misconduct as a whole.” The Court remanded for the district court to reevaluate Laurain’s deceptive intent based on her misconduct in the aggregate and to do the same for prosecution counsel.

The following Gibson Dunn lawyers assisted in preparing this update: Blaine Evanson, Jaysen Chung, Audrey Yang, Al Suarez, Evan Kratzer, and Michelle Zhu.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding developments at the Federal Circuit. Please contact the Gibson Dunn lawyer with whom you usually work, any leader or member of the firm’s Appellate and Constitutional Law or Intellectual Property practice groups, or the following authors:

Blaine H. Evanson – Orange County (+1 949.451.3805, bevanson@gibsondunn.com)
Audrey Yang – Dallas (+1 214.698.3215, ayang@gibsondunn.com)

Appellate and Constitutional Law:
Thomas H. Dupree Jr. – Washington, D.C. (+1 202.955.8547, tdupree@gibsondunn.com)
Allyson N. Ho – Dallas (+1 214.698.3233, aho@gibsondunn.com)
Julian W. Poon – Los Angeles (+ 213.229.7758, jpoon@gibsondunn.com)

Intellectual Property:
Kate Dominguez – New York (+1 212.351.2338, kdominguez@gibsondunn.com)
Y. Ernest Hsin – San Francisco (+1 415.393.8224, ehsin@gibsondunn.com)
Josh Krevitt – New York (+1 212.351.4000, jkrevitt@gibsondunn.com)
Jane M. Love, Ph.D. – New York (+1 212.351.3922, jlove@gibsondunn.com)

If SB 205 is signed into law, it would go into effect on February 1, 2026, and Colorado would become the first state to enact legislation regulating the development and deployment of high-risk AI systems generally.

On May 8, 2024, Colorado’s Legislature passed SB24-205, the Colorado Artificial Intelligence Act (“SB 205”). SB 205 seeks to govern the use of high-risk AI systems in the private sector. If SB 205 is signed into law by Colorado Governor Jared Polis—which he is expected to do—it would go into effect on February 1, 2026, and Colorado would become the first state to enact legislation regulating the development and deployment of high-risk AI systems generally.

Although SB 205 would be the most comprehensive AI-specific state law, it is not the only state to move in this area in 2024. This year alone, Utah and Tennessee enacted AI legislation (tackling consumer deception by generative AI and AI deepfakes, respectively), while the California Consumer Privacy Protection Agency (“CPPA”) has been making progress with its draft regulations related to automated decision-making technology (“ADMT”).

SB 205 is effectively an anti-discrimination law that would regulate the use of high-risk AI systems by imposing a slew of requirements on developers and deployers, including notice, documentation, disclosures, and impact assessments. SB 205’s focus on high-risk AI systems is similar to the risk-based approach taken by the European Union’s AI Act. Accordingly, companies looking to design a compliance regime to respond to these developments may find opportunities for overlap in these frameworks (e.g., by leveraging ISO’s 42001).

Structurally, SB 205 would become Part 16 within Colorado’s Consumer Protection Act, which already houses the Colorado Privacy Act. SB 205 expressly states that Part 16 does not provide the basis for a private right of action and that the Attorney General has “exclusive” enforcement authority.

Below are 6 key takeaways.

6 Key Takeaways for the Private Sector

Broad Cross-Sectoral Coverage of High-Risk AI Systems: High-risk AI systems are defined as any AI system that, when deployed, makes, or is a substantial factor in making, a consequential decision. A “consequential decision” is one that has a “material legal or similarly significant effect on the provision or denial to any consumer of, or the cost or terms of” education, employment or an employment opportunity, financial/lending services, housing, insurance, healthcare, essential government services, and legal services. Meanwhile, a “substantial factor” must (1) assist in making the consequential decision; (2) be capable of altering the outcome of a consequential decision; and (3) be generated by an AI system. There is ambiguity regarding what this means in practice as it is unclear what would constitute “assisting” in the consequential decision or being “capable” of altering the outcome. This language bears some similarity to that of the CPPA’s current draft ADMT regulations, which would cover training ADMT that is merely capable of being used for a significant decision concerning a consumer.
- Further, unlike the Colorado Privacy Act, SB 205 does not provide an exemption for the employment context. Instead, a “consumer” is defined as “an individual who is a Colorado resident,” and the law specifically intends to cover consequential decisions including related to employment and employment opportunities.
- Examples of specifically excluded tools include calculators, databases, data storage, anti-virus software, networking, spreadsheets, spam-filtering, data storage, cybersecurity, and chatbots subject to an accepted use policy prohibiting the generation of discriminatory or harmful content. The latter exclusion could be fairly significant given the number of “chatbots” being deployed by companies as could the exclusion of tools for cybersecurity—which often are subject to discussion under privacy laws given their unique but sometimes significant use of information.

Exclusive Enforcement by the Attorney General: SB 205 provides that the Attorney General would have “exclusive” authority to enforce the law and promulgate rules to implement the law regarding documentation, notice, impact assessments, risk management policies and programs, rebuttable presumptions, and affirmative defenses. The text specifies that violations of SB 205 do not provide the basis for a private right of action. Notably, SB 205 provides the following two affirmative defenses if the Attorney General commences an action.
- Robust AI Governance Programs: SB 205 would provide an affirmative defense if a deployer has implemented and maintained a risk management policy or program that complies with national or international risk management frameworks such as the National Institute of Standards and Technology’s (“NIST”) AI Risk Management Framework (“AI RMF”) or the International Organization for Standardization’s (“ISO”) 42001.
- Cured Violations: SB 205 would also provide an affirmative defense for a developer or deployer that discovers and cures the violation due to (a) feedback, (b) adversarial testing or red teaming (under NIST’s definition), or (c) an internal review process and is otherwise in compliance with NIST’s AI RMF or ISO’s 42001.

Developers and Deployers Are Subject to an Anti-Algorithmic Discrimination Duty: SB 205 expressly covers both developers and deployers of high-risk AI systems and would require both to use reasonable care to protect consumers from any known or reasonably foreseeable algorithmic discrimination.
- Algorithmic discrimination is defined as any condition in which the use of an AI system results in unlawful differential treatment or impact based on an array of protected classes under Colorado and federal law, including race, disability, age, gender, religion, veteran status, and genetic information. Using an AI system to expand an applicant pool to increase diversity or remedy historical discrimination would not constitute algorithmic discrimination under SB 205. The law provides a narrow exemption for certain deployers with fewer than 50 employees that do not use their own data to train or further improve the AI system.
- A rebuttable presumption is available in the event of an enforcement action. The law would establish a rebuttable presumption that reasonable care was used to avoid algorithmic discrimination if certain compliance indicators (which differ between developers and deployers) are met:
  - Compliance indicators for developers include: (a) providing sufficient information and documentation to deployers such that an impact assessment can be completed; (b) disclosing to the Attorney General and deployers any known or reasonably foreseeable risk of algorithmic discrimination within 90 days of discovery; (c) publishing a publicly available statement regarding the high-risk systems developed and how any known or reasonably foreseeable risks of algorithmic discrimination are being managed; and (d) the purpose and intended benefits and uses of the AI system.
  - Meanwhile, compliance indicators for deployers include: (a) implementing a risk management policy and program; (b) completing an impact assessment; (c) providing notice to consumers; (d) disclosing to the Attorney General any algorithmic discrimination within 90 days of discovery; and (e) publishing a publicly available statement summarizing the high-risk AI system being deployed and any known or reasonably foreseeable risks of algorithmic discrimination that may arise.

Impact Assessments Required: In alignment with trends in other proposed state legislation, SB 205 would require deployers to complete an impact assessment annually, and also within 90-days of any intentional or substantial modification to the high-risk AI system. The impact assessment must include the purpose, intended use cases, benefits, known limitations, and deployment context of the high-risk AI system, any transparency measures taken, post-deployment monitoring and safeguards implemented, and the categories of data used as inputs and the outputs produced. Notably, deployers would be permitted to use a comparable impact assessment that was completed for purposes of complying with another applicable law or regulation. As noted above, completing an impact assessment is one of the indicators that would support a deployer in establishing a rebuttable presumption that reasonable care was used to avoid algorithmic discrimination.

Notice to Consumers is Key: Similar to other, more narrow AI state and local laws already in effect (g., Utah’s AI Policy Act and New York City’s Local Law 144), deployers must notify consumers of the use of a high-risk AI system, the purpose of the system, the nature of the consequential decision, a description of how the system works, and, if applicable, the consumer’s right to opt out of the processing of personal data for purposes of profiling under Section 6-1-1306 of the Colorado Privacy Act. Notably, consumers subject to an adverse consequential decision must be provided with an opportunity to appeal the decision. In alignment with the European Union’s AI Act, if it is “obvious” that a consumer is interacting with an AI system, SB 205 would not mandate such a disclosure.
A Violation is Also a “Deceptive Trade Practice” Under Colorado Law: On its final page, SB 205 provides that a violation of Part 16 would constitute a “deceptive trade practice” under Colorado Revised Statutes, Section 6-1-105, which resides in Part 1 of Colorado’s Consumer Protection Act. Note that under Part 1, consumers injured by a “deceptive trade practice” are provided with the ability to bring a civil action. At this stage, it remains unclear whether this was intended to indirectly create a private right of action under Part 1, or if the legislature inadvertently failed to make an express disclaimer (e., “Notwithstanding any provision in Part 1, Part 16 does not authorize a private right of action.”).

The following Gibson Dunn lawyers assisted in preparing this update: Vivek Mohan, Cassandra Gaedt-Sheckter, Natalie Hausknecht, Eric Vandevelde, and Emily Maxim Lamm.

Gibson, Dunn & Crutcher’s lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn lawyer with whom you usually work, any leader or member of the firm’s Artificial Intelligence practice group, or the authors:

Cassandra L. Gaedt-Sheckter – Palo Alto (+1 650.849.5203, cgaedt-sheckter@gibsondunn.com)
Natalie J. Hausknecht – Denver (+1 303.298.5783, nhausknecht@gibsondunn.com)
Vivek Mohan – Palo Alto (+1 650.849.5345, vmohan@gibsondunn.com)
Robert Spano – Paris/London (+33 1 56 43 14 07, rspano@gibsondunn.com)
Eric D. Vandevelde – Los Angeles (+1 213.229.7186, evandevelde@gibsondunn.com)
Emily Maxim Lamm – Washington, D.C. (+1 202.955.8255, elamm@gibsondunn.com)

Observations and drafting suggestions for CRE terms in merger agreements, licenses, and royalty purchase agreements.

On April 30, 2024, the Delaware Court of Chancery held that the buyer in a life sciences merger and its successor had not breached their contractual obligations under an earn-out provision to use commercially reasonable efforts (“CRE”) to achieve regulatory approvals for a pharmaceutical product. In Himawan, et al. v. Cephalon, Inc., et al., Vice Chancellor Glasscock found that the merger agreement’s definition of CRE for purposes of the earn-out provision, which referred to the efforts of a company with substantially the same resources and expertise as the buyer, required the Court to analyze whether a reasonable actor faced with the circumstances would continue to pursue the development of a drug that had failed to meet one of its co-primary endpoints in an earlier clinical trial.[1] In its reasoning, the Court relied heavily on the merger agreement’s grant to the buyer of “complete discretion with respect to all decisions” over the development activities, subject only to the more general CRE obligation. Although the impact of the decision on CRE clauses granting a buyer less discretion remains to be seen, the Court’s decision provides important guidance on the interpretation and drafting of CRE clauses generally, both in merger agreements and in other contexts, such as license agreements and revenue sharing agreements.

Background

The plaintiffs in the case were representatives of former Ception Therapeutics, Inc. (“Ception”) stockholders. Ception owned the antibody Reslizumb (“RSZ”), which was being developed for treating inflammation in the lungs (eosinophilic asthma, or “EA”) and the esophagus (eosinophilic esophagitis, or “EoE”). Cephalon Inc. (“Cephalon”) acquired Ception in April 2010 with the intent to develop and commercialize RSZ to treat EA and EoE. Two years later, in October 2012, Teva Pharmaceutical Industries Ltd. (“Teva”) acquired Cephalon.

Under the Merger Agreement, Ception stockholders had the right to receive two milestone payments of up to $200 million each for regulatory approval of RSZ for the treatment of EA and EoE (for a total of up to $400 million). In the context of addressing the earn-out consideration, the Merger Agreement provided that the buyer would have “complete discretion with respect to all decisions related to the business of the Surviving Corporation and its subsidiaries, including decisions relating to the research, development, … pricing and distribution of [RSZ], and shall have no obligation to conduct clinical trials related to, or otherwise pursue regulatory approvals of, any indication for [RSZ] … or otherwise take any action to protect, attain or maximize any payment to be received by” stockholders under the earn-out. Notwithstanding the flexibility afforded under this language, the buyer remained subject to an overarching obligation to use “commercially reasonable efforts” to develop and commercialize RSZ in furtherance of the development milestones. “Commercially reasonable efforts” was defined in the merger agreement as requiring “the exercise of such efforts and commitment of such resources by a company with substantially the same resources and expertise as [buyer], with due regard to the nature of efforts and cost required for the undertaking at stake.” Teva assumed this obligation when it acquired Cephalon.

The EA-related regulatory milestone events were achieved and Ception stockholders received the corresponding $200 million milestone payment. However, despite bona fide development efforts and engaging multiple times with the FDA to devise a new clinical path forward, the development of RSZ for the treatment of EoE proved unsuccessful and both Cephalon and Teva abandoned the development of RSZ for this indication. Ception stockholders then sued Cephalon and Teva for breach of the Merger Agreement based on a failure to use CRE to develop and commercialize RSZ for the treatment of EoE.

Ruling

In its ruling, the Court held that Teva and Cephalon did not breach the Merger Agreement and did not breach their obligations to use CRE to develop and commercialize RSZ for the treatment of EoE.

In measuring the efforts of Teva and Cephalon against the CRE yardstick, the Court emphasized that the Merger Agreement gave “complete discretion” to the buyer with respect to all decisions related to the business of the seller, only subject to the restriction that Teva and Cephalon could not avoid the earn-outs in a manner that was commercially unreasonable.[2]

The Court then proceeded to interpret the CRE standard to impose a requirement on the buyer as it found itself situated from an objective standard. Thus, if a reasonable actor faced with the same limitations and risks in the development of a pharmaceutical product would go forward in its own self-interest, then the buyer would be contractually obligated to do the same. Notably, the Court found unworkable the plaintiff’s preferred interpretation that the CRE clause required comparing Cephalon and Teva’s efforts with the efforts of similarly situated pharmaceutical companies and their actions in the real world developing different drugs for EoE on the basis that “no exemplar companies operate under the actual conditions” of Cephalon and Teva.[3]

Rule Application

After establishing the framework for review, the Court separately analyzed Cephalon’s efforts and Teva’s efforts, finding that the actions of both parties were commercially reasonable.

With respect to Cephalon, the Court noted that it had engaged in substantive efforts to develop RSZ for the treatment of EoE even after a failed trial, including hiring former Ception employees, holding a pre-Biologics License Application meeting with the FDA in which it “proposed to submit a pre-Biologics License Application for RSZ under an FDA program for accelerated approval of biological products” and the use of a surrogate endpoint, proposing to amend the Open-Label Study to convert it into an efficacy study, and proposing an enriched, enrollment, randomized withdrawal (“EERW”) study. However, the FDA ultimately rejected those proposals, though it provided a recommendation to gain approval through additional data and analyses. Cephalon conducted the requested analyses and ultimately concluded that it could not identify a “clinical benefit” and would discontinue development. The Court noted that similarly situated competitors also abandoned their EoE development programs after failed clinical trials and studies. While the Court took note of these actions to bolster its finding of commercial reasonableness, such comparisons were not determinative in themselves.

The Court arrived at the same conclusion regarding Teva’s development of RSZ for the treatment of EoE. When Teva acquired Cephalon, Teva did not restart the EoE program, but instead focused on EA from 2011 to 2017. The Court reasoned that Teva’s prioritization of treating EA was objectively reasonable because it was more promising clinically and commercially in comparison with treating EoE, which had already faced numerous regulatory hurdles and clinical setbacks. Teva “hired RxC, a third-party biopharma strategy consulting firm that specializes in pharmaceutical life cycle planning and new product commercialization, to conduct an opportunity assessment of RSZ for EoE.” RxC concluded that the probability of starting a successful new trial was low and that the commercial viability provided limited upside. Teva had determined that it would only be commercially reasonable to develop RSZ for the treatment of EoE if it could obtain a viable subcutaneous route of administration because RSZ was already a challenging commercial product in any indication as it required administration by infusion and the display of a black-box warning label. Teva’s clinical trials of the subcutaneous form of RSZ failed to demonstrate efficacy for the treatment of EA, and so Teva decided it would not pursue the development of RSZ for EoE. Teva had also considered the related milestone payments under the Merger Agreement in concluding that the further development of RSZ for the treatment of EoE was impractical.

Drafting Guidance

The Court’s ruling provides important guidelines for negotiating and drafting CRE definitions in the context of a variety of agreements, including merger agreements, license agreements, and synthetic royalty financing agreements. The Court focused not only on the definition of CRE, but also on surrounding language and the discretion expressly afforded the buyer with regard to the seller’s business. Sellers in future transactions might consider not including any express discretion language with respect to the buyers’ development and commercialization activities in order to bolster the objective measure of the CRE standard. Buyers, on the other hand, might consider including express discretion language in order to bolster the subjective measure of the CRE standard.

The Court’s decision suggests that CRE definitions drafted with reference to the buyer’s specific facts and circumstances will provide buyers with significantly more freedom in the interpretation of commercial reasonableness. While the Court indicated that it was utilizing an “objective” standard to measure CRE, this objectivity was not determined by looking to the efforts of similarly-situated pharmaceutical companies and their actions in the real world with respect to similar drug candidates, but rather by considering whether a reasonable person in the same situation as the buyer (i.e., considering the same opportunities and risks) would go forward in its own self-interest (sometimes referred to as a “subjective objective standard”).

The Court’s ruling notes that applying a purely objective standard is unworkable (or at least challenging to implement), as each set of circumstances around drug development is inherently unique. Simply because other companies had pursued the development of different drugs for the same indication does not provide insight into whether it would be reasonable to require similar efforts in the context of a different drug for the same disease. Rather, the Court applied an objective standard of reasonableness in the context of the buyer’s unique facts and circumstances.

Adopting that interpretative framework, parties in future transactions may consider the following options in drafting CRE terms that accomplish their desired objectives:

M&A Buyer/Licensee Side:[4] The buyer/licensee should define “Commercially Reasonable Efforts” with a subjective standard benchmarked only against itself.

“… shall use those efforts and resources that such Party would typically devote to its owned or exclusively licensed products for the same clinical indication and in the same geographic markets with a similar market potential at a similar stage in development or product life, taking into account intellectual property protection, efficacy, safety, approved labeling, the competitiveness of alternative products in such jurisdiction, pricing/reimbursement for the pharmaceutical product and the profitability of the pharmaceutical product (including with regard to the costs associated with the [earn-out payments]), all as measured by the facts and circumstances in existence at the time such efforts are due.”

M&A Seller/Licensor Side:[5] The seller/licensor should define “Commercially Reasonable Efforts” with an objective standard benchmarked against similarly situated companies as the buyer/licensee, or if possible, an objective standard with specific minimum requirements.

“… shall use those efforts and resources consistent with the usual and customary practices of a similarly situated biopharmaceutical company in the development and exploitation of a drug product owned by or licensed to it, which drug product is at a similar stage of development, is in a similar therapeutic and disease area, and is of similar market potential and without regard to the costs associated with the [earn-out payments] [(provided that, in any event, the number of full time sales representatives of the Company with respect to the Product shall not fall below [___])][6].”

__________

[1] Himawan, et al. v. Cephalon, Inc., et al., C.A. No. 2018-0075-SG (Del. Ch. Apr. 30, 2024).

[2] In coming to this conclusion, the Court distinguished the current context from other cases involving CRE that the plaintiffs cited. In the current context, the buyer had complete discretion over development, cabined only by CRE. On the other hand, in the other cited cases, the merger agreement required the parties to use CRE to achieve one of the milestones as a precursor to consummation of the transaction, and to use reasonable best efforts to consummate the transaction. As a result, if the milestone did not occur and could prevent the completion of the merger, the buyer was affirmatively obligated to take all reasonable steps necessary to achieve the milestone in order to complete the merger.

[3] The plaintiffs had argued that companies with similar resources and expertise (specifically, Shire, Sanofi and Regeneron, Celgene, and GlaxoSmithKline) were pursuing products for treatment of EoE and thus suggesting that Cephalon/Teva was unreasonable in not pursuing approval in the indication. The Court found this to be an apples-to-oranges comparison that was unworkable.

[4] Also aligned with the perspective of the seller of a synthetic royalty interest.

[5] Also aligned with the perspective of the buyer of a synthetic royalty interest.

[6] Where the counterparty expects the expenditure of a minimum level of resources, consider setting an explicit floor for CRE (e.g., with reference to a minimum level of expenditures or minimum number of full-time-equivalent employees working to develop or commercialize the product).

The following Gibson Dunn lawyers prepared this update: Ryan A. Murr, Karen A. Spindler, Todd J. Trattner, Marina Szteinbok, and Artin Au-Yeung.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding the issues discussed in this update. Please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any leader or member of the firm’s Mergers & Acquisitions or Life Sciences practice groups:

Life Sciences:
Jane M. Love, Ph.D. – New York (+1 212.351.3922, jlove@gibsondunn.com)
Ryan Murr – San Francisco (+1 415.393.837, rmurr@gibsondunn.com)
Karen Spindler – San Francisco (+1 415.393.8298, kspindler@gibsondunn.com)
Todd Trattner – San Francisco (+1 415.393.8206, ttrattner@gibsondunn.com)

Mergers and Acquisitions:
Robert B. Little – Dallas (+1 214.698.3260, rlittle@gibsondunn.com)
Saee Muzumdar – New York (+1 212.351.3966, smuzumdar@gibsondunn.com)
Marina Szteinbok – New York (+1 212.351.4075, mszteinbok@gibsondunn.com)

Warner Chappell Music, Inc. v. Nealy, No. 22-1078 – Decided May 9, 2024

Today, the Supreme Court held 6-3 that a copyright plaintiff can recover damages for any timely claim of infringement, even if the infringement occurred more than three years before the suit’s filing.

“The Copyright Act entitles a copyright owner to recover damages for any timely claim.”

Justice Kagan, writing for the Court

Background:

The Copyright Act requires that claims for copyright infringement be brought “within three years after the claim accrued.” 17 U.S.C. § 507(b). In 2018, independent record-label owner Sherman Nealy sued Warner Chappell Music, Inc. for alleged copyright infringement roughly a decade after the alleged infringement began, and almost three years after he allegedly discovered the infringement. Warner Chappell accepted that the claim accrued when the alleged infringement was discovered but argued that Nealy could only recover damages or profits for infringement occurring in the last three years, citing Petrella v. Metro-Goldwyn-Mayer, 572 U.S. 663, 672 (2014). The district court agreed with Warner Chappell but certified the question to the Eleventh Circuit, which reversed. The Eleventh Circuit assumed that the discovery rule governed the timeliness of the claim and held that the Copyright Act does not limit the time for collecting damages.

Issue:

Whether, under the discovery accrual rule applied by the circuit courts and the Copyright Act’s statute of limitations for civil actions, 17 U.S.C. § 507(b), a copyright plaintiff can recover damages for acts that allegedly occurred more than three years before the filing of a lawsuit.

Court’s Holding:

Yes. Assuming (without deciding) that a copyright infringement claim is timely if brought within three years after the plaintiff discovered the alleged infringement, the plaintiff may recover damages for any infringement, even if it occurred more than three years before a lawsuit’s filing.

What It Means:

Justice Kagan, writing for a six-Justice majority, based the Court’s holding on the plain text of the Copyright Act. The Court noted that the Copyright Act’s statute of limitations specifies a three-year time limit for filing an infringement claim “after the claim accrued.” 17 U.S.C. § 507(b). By contrast, the Copyright Act’s remedial provisions do not specify any time limit for recovering damages and lost profits. 17 U.S.C. § 504(a)-(c). Therefore, the Court concluded, “a copyright owner possessing a timely claim for infringement is entitled to damages, no matter when the infringement occurred.” Op. 5.
The Court acknowledged that some language in the Court’s decision in Petrella v. Metro-Goldwyn-Mayer, 572 U.S. 663 (2014), could be read out of context to suggest a limit on the time a copyright plaintiff can recover retrospective relief. However, the Court explained that in the context of that case, the plaintiff had sued “only for infringements that occurred in the three years before her suit.” Op. 7.
Importantly, the Court expressly assumed (without deciding) that Nealy’s infringement claims were timely under the discovery rule of accrual. But the Court noted that the Court has “never decided whether that assumption is valid—i.e., whether a copyright claim accrues when a plaintiff discovers or should have discovered an infringement, rather than when the infringement happened.” Op. 4.
Three Justices, in an opinion written by Justice Gorsuch and joined by Justices Thomas and Alito, dissented and would have dismissed the case as improvidently granted. The dissenters disagreed with the assumption that Nealy’s claims were valid under the discovery accrual rule because, in their view, the Copyright Act “almost certainly does not tolerate a discovery rule.” Dissenting Op. 1.
Today’s decision, along with the dissent, likely means that the Court will soon be asked to decide whether claims for copyright infringement are timely under the discovery accrual rule. If they are not—that is, if claims for infringement must be brought within three years of the infringement itself rather than its discovery—then the import of today’s decision may be limited.

The Court’s opinion is available here.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding developments at the U.S. Supreme Court. Please feel free to contact the following practice leaders:

Appellate and Constitutional Law Practice

Thomas H. Dupree Jr. +1 202.955.8547 tdupree@gibsondunn.com	Allyson N. Ho +1 214.698.3233 aho@gibsondunn.com	Julian W. Poon +1 213.229.7758 jpoon@gibsondunn.com
Lucas C. Townsend +1 202.887.3731 ltownsend@gibsondunn.com	Bradley J. Hamburger +1 213.229.7658 bhamburger@gibsondunn.com	Brad G. Hubbard +1 214.698.3326 bhubbard@gibsondunn.com

Related Practice: Media, Entertainment and Technology

Scott A. Edelman +1 310.557.8061 sedelman@gibsondunn.com	Kevin Masuda +1 213.229.7872 kmasuda@gibsondunn.com	Benyamin S. Ross +1 213.229.7048 bross@gibsondunn.com
Jillian N. London +1 213.229.7671 jlondon@gibsondunn.com	Ilissa Samplin +1 213.229.7354 isamplin@gibsondunn.com	Brian C. Ascher +1 212.351.3989 bascher@gibsondunn.com

Related Practice: Intellectual Property

Kate Dominguez +1 212.351.2338 kdominguez@gibsondunn.com	Y. Ernest Hsin +1 415.393.8224 ehsin@gibsondunn.com	Josh Krevitt +1 212.351.4000 jkrevitt@gibsondunn.com
Jane M. Love, Ph.D. +1 212.351.3922 jlove@gibsondunn.com	Howard S. Hogan +1 202.887.3640 hhogan@gibsondunn.com

This alert was prepared by partner Jillian London and associate Branton Nestor.

We are pleased to provide you with Gibson Dunn’s ESG monthly updates for April 2024. This month our update covers the following key developments. Please click on the links below for further details.

I. GLOBAL

Negotiations on global plastics treaty progress in Ottawa

From April 23 to 29, the Intergovernmental Negotiating Committee (INC) assembled in Ottawa, Canada, to progress negotiations regarding an international legally binding instrument on plastic pollution, which is intended to address the full life cycle of plastic, including its production, design, and disposal. The session concluded with an advanced draft text of the instrument and agreement on intersessional work ahead of the fifth session, which takes place in Busan, South Korea, in November.

Automakers and suppliers collaborate to standardize emissions reporting

Global automakers and suppliers have collaborated to release the Automotive Climate Action Questionnaire, aimed at improving consistency in Scope 3 emissions reporting. Participating automakers and suppliers include Ford Motor Company, General Motors, Honda Development & Manufacturing of America, Denso and Toyota Motor North America. The questionnaire provides a standardized template to collect supplier information to measure, manage and reduce carbon emissions within their supply chains.

Basel Committee on Banking Supervision publishes discussion paper on climate scenario analysis

On April 16, the Basel Committee on Banking Supervision issued a discussion paper on how climate scenario analysis can be practically used to help strengthen the management and supervision of climate-related financial risks. This follows the principles for the effective management and supervision of climate-related financial risks which were published in 2022 and intends to harmonize supervisory expectations and comparability of results.

Transition Plan Taskforce publishes latest transition plan

On April 9, the Transition Plan Taskforce (TPT) published its final set of transition plan resources. These include sector-specific transition plan guidance for asset owners, asset managers, banks, electric utilities & power generators, food & beverage, metals & mining and oil & gas, sector summary guidance and guidance on the how to undertake a transition planning cycle and paper on the opportunities and challenges of transition plans in emerging markets and developing economies. The TPT was established by HM Treasury and announced at COP26 in Glasgow in November 2021. (HM Treasury is the UK government’s economic and finance ministry, and the TPT is engaging with many countries to help inform their approaches to transition planning.)

Bloomberg launches government climate tilted bond indices

On April 4, Bloomberg announced the launch of the Bloomberg Government Climate Tilted Bond Indices, a new benchmark family for government bond investors. The indices adjust country weights in Bloomberg Treasury and Sovereign indices based on Bloomberg Government Climate Scores (GOVS), which assess a government’s relative preparedness in the transition to a low-carbon world using transparent, data-driven indicators. The GOVS scores, provided by Bloomberg Sustainable Finance Solutions and informed by Bloomberg’s BloombergNEF (BNEF) data, comprise three equally weighted pillars: Carbon Transition, Power Sector Transition and Climate Policy.

International Sustainability Standards Boards votes to start research on biodiversity and human capital

On April 23, the International Sustainability Standards Board (ISSB) announced it will commence a project to research risk disclosures regarding risks and opportunities associated with biodiversity, ecosystems and ecosystem services and human capital. Focus of the project will be the common information needs of investors in assessing whether and how these risks and opportunities could reasonably be expected to affect a company’s prospects. Through the research projects, the ISSB will assess and define the limitations with current disclosure in these areas, identifying possible solutions and decide whether standard setting is required.

UN Environment Programme Finance Initiative launches new Risk Centre addressing sustainability risks

On April 17, the UN Environment Programme Finance Initiative (UNEP FI) unveiled its new Risk Centre aimed at assisting financial institutions in navigating sustainability risks. The Risk Centre, available exclusively to UNEP FI’s members, will offer access to a centralized platform of resources and guidance tailored specifically for risk professionals. Initially focusing on climate and nature risks, including support for frameworks such as the Taskforce on Climate-Related Financial Disclosures and Taskforce on Nature-Related Financial Disclosures, the Risk Centre will later expand its scope to cover other sustainability risks such as pollution and social issues.

Network for Greening the Financial System publishes reports on transition plans

On April 17, the Network for Greening the Financial System (NGFS) published three reports exploring the role of transition plans in enabling the financial system to mobilise capital, manage climate-related financial risks, and the relevance of transition plans to micro-prudential supervision. In particular, the reports (i) explore the needs and challenges of emerging market and developing economies related to transition plans, (ii) assess the interlinkages between the transition plans of the real economy and of financial institutions and (iii) examine the credibility of financial institutions’ transition plans and processes from a micro-prudential perspective.

Loan Market Association publishes form Sustainability Coordinator Letter

On April 24, the Loan Market Association (LMA) published a form of Sustainability Coordinator Letter intended to provide a starting point for negotiations where a sustainability coordinator is to be appointed on a sustainable lending transaction. The form is available to members on the LMA website.

Institutional Shareholder Services releases ESG Performance Chartbook for the industrials, financials and real estate sectors

On April 30, ISS ESG Solutions, part of Institutional Shareholder Services, released its ESG Performance Chartbook. The goal of the ESG Performance Chartbook series is to provide insights into the distribution of ESG Performance Scores per industry within a sector. The charts are based on the underlying data from ISS ESG Solutions’ ratings methodology.

II. UNITED KINGDOM

British Standards Institute publishes Net Zero Transition Plans Code of Practice

On March 31, the British Standards Institute (BSI) published BSI Flex 3030 – Net Zero Transition Plans – Code of Practice. The BSI Flex is designed to help small and medium-sized enterprises apply high level principles to design and deliver their transition to net zero and link their net zero transition plans with their wider sustainability or ESG reporting.

Financial Conduct Authority launches consultation on extending labels regime to portfolio management

On April 23, the Financial Conduct Authority (FCA) launched a consultation process on extending the Sustainability Disclosure Requirements (SDR) and investment labels regime to portfolio management services. The consultation follows on an earlier consultation paper and corresponding policy statement (published in November 2023) on SDR and investment labels, which introduced a package of measures for fund managers. The process is open for comments until June 14.

UK government announces aviation fuel plans

On April 25, the UK government confirmed new targets to ensure 10% of all jet fuel in flights taking off from the UK comes from sustainable sources by 2030 through its sustainable aviation fuel (SAF) mandate. The SAF mandate will, subject to parliamentary approval, come into force in January 2025.

III. EUROPE

European Parliament approves Corporate Sustainability Due Diligence Directive

On April 24, the European Parliament passed the Corporate Sustainability Due Diligence Directive, meaning the directive has now passed all legislative phases. Once signed into law by the EU Council, EU member states will be given two years to transpose the directive into national laws. Under the directive, companies will need to conduct human rights and environmental due diligence on their own operations, their subsidiaries and their supply chain both within and outside the European Union.

Enforcement is scheduled to begin in 2027 for companies with over 5,000 employees and annual turnover of more than €1.5 billion, in 2028 for companies with more than 3,000 employees and €900 million in turnover, and in 2029 for companies with more than 1,000 employees and €450 million in turnover. Non-EU companies, parent companies and companies with franchising or licensing agreements in the EU reaching the same turnover thresholds in the EU will also be required to comply.

European Parliament adopts new regulation to reduce methane emissions

On April 10, the European Parliament voted to approve a provisional agreement with the EU member countries on a new law aimed at reducing methane emissions from the energy sector. The new regulation covers direct methane emissions from the oil, fossil gas and coal sectors, and from biomethane once it is injected into the gas network. The final act now has to be adopted by the Council of the European Union before being published in the EU Official Journal and entering into force 20 days later.

European Court of Human Rights rules on Swiss climate policies

On April 9, the European Court of Human Rights (ECHR) ruled in favour of a Swiss association which had argued the Swiss government was not taking sufficient action to mitigate the effects of climate change. The ECHR found that the European Convention on Human Rights (Convention) encompasses a right to effective protection by the State authorities from the serious adverse effects of climate change on lives, health, well-being and quality of life and that there had been a violation of the right to respect for private and family life of the Convention. Further, the it held that the Swiss government had failed to comply with its duties (“positive obligations”) under the Convention concerning climate change by failing to comply with its own targets for cutting greenhouse gas emissions and to set a national carbon budget.

European Commission opens two investigations regarding subsidies for solar manufacturers

On April 3, the European Commission announced it had launched two in-depth investigations under the Foreign Subsidies Regulation, relating to the potentially market distortive role of foreign subsidies given to bidders in a public procurement procedure. Focus of the probe are two consortiums bidding for the development of a solar park in Romania, part-financed by EU funds. The European Commission will assess whether the economic operators concerned did benefit from an unfair advantage to win public contracts in the European Union.

According to the Foreign Subsidies Regulation, companies are obliged to notify their public procurement tenders in the European Union when the estimated value of the contract exceeds €250 million, and when the company was granted at least €4 million in foreign financial contributions from at least one third country in the three years prior to notification.

European Parliament votes to leave Energy Charter Treaty

On April 24, the European Parliament voted for the European Union to withdraw from the Energy Charter Treaty (ECT). This vote follows a resolution adopted by the European Parliament in 2022 which called for the European Union to exit the ECT. The Council of the European Union can now adopt the decision by qualified majority.

This resolution follows the departure of a number of EU member states as well as the United Kingdom, as reported on in our February Edition.

European Parliament adopts directive on “right to repair”

On April 23, the European Parliament adopted a new directive on the so-called “right to repair” which intend to clarify the obligations for manufacturers to repair goods. The new rules require manufacturers provide certain repair services and inform consumers about their rights to repair. Goods repaired under the warranty will benefit from an additional one-year extension of the legal guarantee. After the legal guarantee has expired, manufacturer would still be required to repair common household products, such as washing machines, vacuum cleaners, and smartphones. Once the directive is formally approved by Council of the European Union and published in the EU Official Journal, member states will have 24 months to transpose it into national law.

European Commission investigates airlines for misleading greenwashing practices

On April 30, the European Commission announced that it sent letters to 20 airlines identifying several types of potentially misleading green claims and inviting them to bring their practices in line with EU consumer law within 30 days. The letters relate to claims made by airlines that the CO₂ emissions caused by a flight could be offset by climate projects or through the use of sustainable fuels, to which the consumers could contribute by paying additional fees. The European Commission is concerned that the identified practices can be considered as misleading actions/omissions, prohibited under the Unfair Commercial Practices Directive.

IV. NORTH AMERICA

SEC stays implementation of new rules to enhance climate-related disclosures

On April 4, the U.S. Securities and Exchange Commission (SEC) issued an Order pausing implementation of new rules adopted in March 2024 requiring public companies to disclose certain climate change-related information in their SEC filings. The Order follows legal challenges by various parties that have been consolidated for review by the Eighth Circuit. In the Order, the SEC noted: “In issuing a stay, the Commission is not departing from its view that the Final Rules are consistent with applicable law and within the Commission’s long-standing authority to require the disclosure of information important to investors in making investment and voting decisions. Thus, the Commission will continue vigorously defending the Final Rules’ validity in court and looks forward to expeditious resolution of the litigation.”

Reminder for resource extraction issuers

SEC rules that became final in March 2021 (available here) require additional disclosures by public companies that engage in the commercial development of oil, natural gas or minerals. Under the final rule, domestic or foreign “resource extraction issuers” are required to annually disclose information about certain payments made to foreign governments or the U.S. federal government on Form SD.

The final rule allowed for a two-year transition period after the effective date, with initial Form SD filings due no later than 270 calendar days after the end of an issuer’s next completed fiscal year (e.g., September 26, 2024 for issuers with a December 31, 2023 fiscal year end). While the adopting release specifically referred to September 30, 2024 as the due date for a company with a fiscal year end of December 31, 2023 (274 days after year end), we recommend filing the Form SD by September 26, 2024 to ensure timely compliance with the rule’s deadline. More information on these filings is available in our recent client alert.

NYC Comptroller and NYC Public Pension Boards reach agreement on climate finance disclosures

On April 4, New York City Comptroller Brad Lander announced agreements with JPMorgan Chase, Citigroup, and Royal Bank of Canada whereby the banks will regularly disclose their ratio of clean energy supply financing to fossil fuel extraction financing and their underlying methodology. The new agreements follow the submission of shareholder proposals for 2024 annual meetings by three of New York City’s pension funds – the New York City Employees’ Retirement System, the Teachers’ Retirement System, and the Board of Education Retirement System (BERS) – at several banks asking each to disclose the new metric.

Federal civil rights complaint filed against Shake Shack

As reported on in our DEI Task Force Update, on April 25, America First Legal (AFL), the conservative organization founded and run by former Trump policy advisor Stephen Miller, announced that it had filed a federal civil rights complaint with the EEOC against Shake Shack, Inc., alleging race and sex discrimination in violation of Title VII. AFL claims that Shake Shack discriminates on the basis of race and sex by unlawfully considering the protected characteristics of applicants and employees when making employment decisions. In support of these allegations, AFL cites the company’s May 2023 Proxy Statement, in which Shake Shack outlined its “5-Year Diversity Targets” that concentrate on women and people of color. Specifically, Shake Shack set a goal for 50% of its leadership roles to be occupied by people of color by the end of 2025, and also mandated that at least two underrepresented minorities, women, or people of color be interviewed when hiring for leadership positions. AFL highlights Shake Shack’s June 2023 update on its DEI goals, as well, where the company cited a 33% increase in the representation of women and an 18% increase in people of color in leadership positions since establishing its 2025 diversity goals. AFL also sent a cease and desist letter to Shake Shack’s CEO and Board of Directors demanding that the company end its allegedly discriminatory employment practices.

New federal contracts regulations on sustainability

On April 22, the FAR Council (U.S. Department of Defense, General Services Administration, and National Aeronautics and Space Administration) published final rules amending the Federal Acquisition Regulation (FAR) to focus on current environmental and sustainability matters and to implement a requirement for agencies to procure sustainable products and services to the maximum extent practicable. Draft rules had previously been published in August 2023 and the final rules include a number of clarifications to the FAR.

Biden administration announces $20 billion in grants to finance clean energy projects in low income communities

On April 4, the Biden administration announced its selection for $20 billion in grant awards under two competitions within the $27 billion Greenhouse Gas Reduction Fund (GGRF), which was created under the Inflation Reduction Act. The GGRF consists of a series of programs designed to finance clean technology deployment that also includes building the capacity of community lenders to provide financing for clean energy projects. Over 70% of the new awards will be directed to low-income and disadvantaged communities.

V. APAC

Japan releases proposed IFRS based sustainability reporting standards

On April 5, 2024, the Sustainability Standards Board of Japan (SSBJ) announced the release of new drafts for proposed reporting standards regarding sustainability and climate-related information, which are intended to align with the sustainability disclosure standards by the IFRS Foundation’s International Sustainability Standards Board (ISSB).

The SSBJ has released the standards as three exposure drafts, as opposed to the ISSB’s two standards, by dividing IFRS 1 (general sustainability) into two standards. A summary of the differences between its exposure drafts and the ISSB standards has been provided by the SSBJ. The SSBJ is currently soliciting feedback on the exposure drafts.

Singapore Monetary Authority launches sustainable finance jobs transformation map

On April 17, 2024, the Monetary Authority of Singapore (MAS) and Institute of Banking and Finance (IBF), supported by Workforce Singapore (WSG), launched the “sustainable finance jobs transformation map”, which lays out the impact of sustainability trends on jobs in Singapore’s financial services sector and the emerging skills that are predicted to be required to serve sustainable financing demand in the region. The MAS also set aside S$35 million in funds to support upskilling and reskilling, and develop specialists in sustainable finance over the next three years.

Hong Kong Stock Exchange Consultation on Aligning Disclosure Standard with ISSB

On April 19, 2024, the Stock Exchange of Hong Kong (HKEX) published the conclusions of its consultation on the enhancement of climate-related disclosures under its environmental, social and governance (ESG) framework. Following the feedback received, the HKEX will adopt its consultation proposals, modified to reflect IFRS S2 Climate-related Disclosures (IFRS S2) more closely.

The amended listing rules will come into effect on January 1, 2025 and a phased approach for the implementation of the new climate requirements has been laid out by HKEX.

ASEAN Taxonomy Board releases Version 3 of its Sustainable Finance Taxonomy

In March 2024, the ASEAN Taxonomy Board (ATB) released Version 3 of the ASEAN Taxonomy for Sustainable Finance (ASEAN Taxonomy), part of its overarching taxonomy to advance sustainable finance practices across the region. The ASEAN Taxonomy adopts a multi-tiered framework which allows assessment of sustainable activities through either the principles-based Foundation Framework, or the Plus Standard with a more detailed methodology using application of technical screening criteria (TSC). Having published TSC for Electricity, Gas, Steam and Air Conditioning Supply (Energy) sector in ASEAN Taxonomy Version 2, the ASEAN Taxonomy Version 3 introduces TSC for two more focus sectors, namely Transportation & Storage and Construction & Real Estate, which covers activities including construction and renovation of buildings and acquisition and ownership of buildings, as well as urban and freight transport, and infrastructure for land, water, and air transport, among others.

Warmest regards,
Susy Bullock
Elizabeth Ising
Perlette M. Jura
Ronald Kirk
Michael K. Murphy
Selina S. Sagayam

Chairs, Environmental, Social and Governance Practice Group, Gibson Dunn & Crutcher LLP

For further information about any of the topics discussed herein, please contact the ESG Practice Group Chairs or contributors, or the Gibson Dunn attorney with whom you regularly work.

The following Gibson Dunn lawyers prepared this update: Elizabeth Ising, Patricia Tan Openshaw, Selina S. Sagayam, and Theresa Witoszynski.

Gibson Dunn lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any leader or member of the firm’s Environmental, Social and Governance practice group:

Environmental, Social and Governance (ESG):
Susy Bullock – London (+44 20 7071 4283, sbullock@gibsondunn.com)
Elizabeth Ising – Washington, D.C. (+1 202.955.8287, eising@gibsondunn.com)
Perlette M. Jura – Los Angeles (+1 213.229.7121, pjura@gibsondunn.com)
Ronald Kirk – Dallas (+1 214.698.3295, rkirk@gibsondunn.com)
Michael K. Murphy – Washington, D.C. (+1 202.955.8238, mmurphy@gibsondunn.com)
Patricia Tan Openshaw – Hong Kong (+852 2214-3868, popenshaw@gibsondunn.com)
Selina S. Sagayam – London (+44 20 7071 4263, ssagayam@gibsondunn.com)

The U.S. Food and Drug Administration’s highly anticipated final rule on laboratory-developed tests was officially published in the Federal Register on Monday, May 6, 2024.

On April 29, 2024, the U.S. Food and Drug Administration (FDA) released its highly anticipated final rule on laboratory-developed tests (LDTs) (“LDT Final Rule”), which was officially published in the Federal Register on Monday, May 6, 2024.[1] The LDT Final rule comes roughly six months after FDA published its proposal to assert jurisdiction over LDTs.[2] In the LDT Final Rule, FDA amended its regulations to make explicit that LDTs fall within the definition of “device” under the Federal Food, Drug, and Cosmetic Act (“FDCA”), subjecting these tests to extensive premarket review and postmarket compliance requirements over a four-year phase-in period.

In this update, we summarize four key takeaways from the LDT Final Rule. First, the LDT Final Rule is largely identical in substance to the 2023 proposed rule. Second, there have been significant changes to FDA’s targeted enforcement discretion policies, which are intended, in part, to allocate the agency’s scarce enforcement resources on a risk-benefit basis. Third, the LDT Final Rule has spurred significant opposition from Congress, suggesting a potential revival of congressional efforts to clarify FDA’s authority over LDTs. And fourth, litigation is coming, bringing some uncertainty as to how final, in fact, the Final LDT Rule is.

The LDT Final Rule makes minimal changes to the FDA regulatory text, consistent with the 2023 proposed rule

Last year, we reported on the small wording changes FDA proposed to make to its regulations. As we noted, FDA planned to make a surgical change to its definition of “in vitro diagnostic products” (“IVDs”), which are deemed to be “devices” under the FDCA in the agency’s regulations. The codified amendment to the regulatory language in the LDT Final Rule is the same as in the proposed rule:

In vitro diagnostic products are those reagents, instruments, and systems intended for use in the diagnosis of disease or other conditions, including a determination of the state of health, in order to cure, mitigate, treat, or prevent disease or its sequelae. Such products are intended for use in the collection, preparation, and examination of specimens taken from the human body. These products are devices as defined in section 201(h) of the Federal Food, Drug, and Cosmetic Act (the act), and may also be biological products subject to section 351 of the Public Health Service Act, including when the manufacturer of these products is a laboratory.[3]

The sole change in the LDT Final Rule is to the authorities listed to 21 C.F.R. Part 809, which governs IVDs. In addition to adding various device authorities introduced in the 2023 proposed rule, FDA also added a reference to section 351 of the Public Health Service Act (“PHSA”), which addresses IVDs that are subject to licensure as biological products, rather than the approval or clearance pathways for most medical devices.[4]

The LDT Final Rule expands the scope of FDA’s enforcement discretion policies, which will help appease opponents of the rule

As in the 2023 proposed rule, the preamble of the LDT Final Rule includes enforcement discretion policies in acknowledgement of the significant changes to industry’s compliance obligations. While some of these policies were the same as originally proposed, there are some differences:

Four-year phase-in of medical device regulatory requirements: In the LDT Final Rule, FDA established a slightly modified version of its proposed phase-in schedule for industry to comply with medical device requirements:
- Stage 1 (1 year after the effective date of the LDT Final Rule, July 5, 2024): Compliance with respect to medical device reports (“MDR”) and correction and removal reporting requirements, and complaint file requirements under the Quality System Regulation (“QSR”). Notably, FDA expects manufacturers to comply with these requirements for the LDTs subject to this phaseout policy before it expects compliance with clearance or approval requirements.
- Stage 2 (2 years after the effective date): Compliance with medical device requirements other than MDR, correction and removal reporting, complaint files, and registration and listing.
- Stage 3 (3 years after effective date): Compliance with respect to QSR requirements other than complaint files.
- Stage 4 (3.5 years after effective date of the final rule): Compliance with respect to premarket review for high-risk LDTs. FDA indicates that it will use the existing device classification rubric for LDTs, with “low,” “medium,” and “high” risk corresponding to Class I, II, and III, respectively. FDA notes that it does not intend to take enforcement against high-risk devices with timely-submitted premarket submissions until the agency completes review of its application. The phase-in period for premarket review notably aligns with the timeframe for renewal of the Medical Device User Fee Amendments (“MDUFA”) in 2027.
- Stage 5 (4 years after effective date of the final rule): Compliance with respect to premarket review for moderate- and low-risk LDTs.[5]
Targeted enforcement discretion policies: FDA has also adopted various enforcement discretion policies based on its assessments of the risks and benefits of certain classes of LDTs. These include a number of new policies in the LDT Final Rule in response to comments.
- FDA plans to continue to exempt from all medical device requirements certain categories of tests that it believes are unlikely to pose significant risks, or are conducted in circumstances that will mitigate those risks, such as being subject to other regulatory oversight. These include LDTs of the type on the market at the time of the 1976 Medical Device Amendments to the FDCA; human leukocyte antigen (“HLA”) tests designed, manufactured, and used within a single laboratory appropriately certified under the Clinical Laboratory Improvement Amendments (“CLIA”); and, tests solely for forensic or law enforcement purposes. In the LDT Final Rule, FDA added to this list LDTs manufactured and performed within the U.S. Department of Defense (“DoD”) or the Veterans Health Administration (“VHA”).[6]
- In the final rule, FDA also adopted an enforcement discretion policy with respect to premarket review requirements for LDTs approved by the New York State Department of Health’s Clinical Laboratory Evaluation Program (“NYS CLEP”). The agency acknowledged that NYS CLEP’s review of high and moderate risk LDTs for analytical and clinical validity mitigated risks of inaccurate or unreliable LDTs.[7]
- Lastly, FDA stated that it would not enforce premarket requirements and most QSR requirements for certain classes of LDTs, based on the lower risk associated with those tests, a specific unmet need for those devices, or both factors.
  - These classes include validated LDTs manufactured and performed by a laboratory integrated within a healthcare system to meet an unmet need of patients receiving care within the same healthcare system—a nod to concerns from academic medical centers.
  - Other classes of LDT subject to this enforcement discretion policy include currently marketed IVDs offered as LDTs prior to the issuance of the LDT Final Rule, provided they are not modified in ways that could affect their basic safety and effectiveness profile, and non-molecular antisera LDTs for rare red blood cell (RBC) antigens manufactured and performed by blood establishments, for which there is no alternative IVD available to meet a patient’s need for a compatible blood transfusion.[8]

FDA also indicated that it could adopt additional enforcement discretion policies in the future, similar to the agency’s policies for COVID-19 and mpox tests during the respective public health emergencies.[9] Indeed, on the same day the agency announced the Final LDT Rule, it also released two draft guidance documents related to public health emergencies.[10] The first guidance document outlines an enforcement discretion policy for “immediate response” tests in the absence of an emergency declaration under FDCA section 564, provided certain validation, FDA notification, and transparency measures are taken.[11] The second guidance document describes FDA’s considerations in adopting enforcement policies for unapproved and uncleared tests during a Section 564 public emergency.[12] Notices announcing both policies were published in the Federal Register on May 6, 2024.[13]

Scrutiny of the LDT Final Rule from Capitol Hill is hot—and heating up—with possible legislative action on the horizon

Republican leadership has swiftly rebuked FDA for issuing the LDT Final Rule, indicating a legislative response may be brewing. Echoing his prior comments on the proposed rule,[14] Sen. Bill Cassidy (R – La.), the ranking member of the Senate Health, Education, Labor and Pensions (“HELP”) Committee, stated that “[t]he FDA does not have the authority to unilaterally increase its regulatory jurisdiction,” that “Congress has made clear across multiple statutes that LDTs are not medical devices subject to FDA regulation,” and that the LDT Final Rule “will undermine access to essential laboratory tests, increase health care costs, and ultimately harm patients.”[15] Similarly, Rep. Cathy McMorris (R – Wash.), the chair of the House Energy and Commerce Committee, denounced the LDT Final Rule as “the latest example of executive branch overreach that will have devastating impacts on patients and families across the country.”[16] Her comments followed a hearing of the House Health Subcommittee on the impact of FDA’s proposed rule, in which leadership from laboratory entities and the medical device industry provided their disparate views.[17]

Indeed, the LDT Final Rule could reinvigorate congressional efforts to pass the Verifying Accurate Leading-Edge IVCT Development Act (“VALID Act”), which failed to become law at the end of 2022,[18] and was most recently introduced in the House of Representatives (but not yet the Senate) in 2023.[19] If passed, the VALID Act would provide FDA clear statutory authority to LDTs as a separate category of medical products (in vitro clinical tests, or “IVCTs”) under a more tailored, risk-based approach—an approach favored by a number of comments to the proposed rule.[20] Nonetheless, the VALID Act faces challenging headwinds, particularly from laboratories and academic medical centers opposed to any FDA regulation of LDTs, and may require an external push in order to succeed. Litigation over the LDT Final Rule—and particularly any outcome that forecloses FDA jurisdiction without statutory changes—may very well be the tipping point for legislative efforts at LDT regulation, especially as negotiations begin on policy riders for the next FDA user fee reauthorization legislation in 2027.

Litigation over the Final LDT Rule is coming

Opponents to the LDT Final Rule have been eager to voice concerns about FDA’s authority to regulate LDTs, with more than 25 groups meeting with the Office of Management and Budget during its review and almost 7,000 comments to the docket for the proposed rule.[21] As shown by the 160-page final rule, as published in the Federal Register, the agency can expect legal challenges on multiple fronts, including its statutory authority to regulate LDTs, First and Fifth Amendment constitutional concerns, and compliance with requirements under the Administrative Procedures Act (“APA”) and the Unfunded Mandates Reform Act (“UMRA”). Thus, the future of FDA’s oversight over LDTs remains far from clear, and the LDT Final Rule is likely to engender even more activity in the long-running saga of regulatory attention to the testing space.

__________

[1] 89 Fed. Reg. 37286 (May 6, 2024).

[2] 88 Fed. Reg. 68006 (Oct. 3, 2023). FDA also published a press release accompanying the proposed rule. FDA News Release, “FDA Proposes Rule Aimed at Helping to Ensure Safety and Effectiveness of Laboratory Developed Tests” (Sept. 29, 2023).

[3] 89 Fed. Reg. at 37444-45 (amending 21 C.F.R. § 809.3(a)).

[4] As amended, the authorities for Part 809 now list the following: “21 U.S.C. 321(h)(1), 331, 351, 352, 360, 360c, 360d, 360e, 360h, 360i, 360j, 371, 372, 374, 381, and 42 U.S.C. 262.” Id.

[5] Id. at 37294.

[6] Id. at 37297-28.

[7] Id. at 37299-301.

[8] Id. at 37301-07.

[9] Id. at 37925.

[10] FDA News Release, “FDA Takes Action Aimed at Helping to Ensure the Safety and Effectiveness of Laboratory Developed Tests” (April 29, 2024).

[11] FDA, Draft Guidance for Laboratory Manufacturers and Food and Drug Administration Staff: Enforcement Policy for Certain In Vitro Diagnostic Devices for Immediate Public Health Response in the Absence of a Declaration under Section 564 (May 2024); see 21 U.S.C. § 360bbb-3.

[12] FDA, Draft Guidance for Industry and Food and Drug Administration Staff: Consideration of Enforcement Policies for Tests During a Section 564 Declared Emergency (May 2024).

[13] 89 Fed. Reg. 37158 (May 6, 2024); 89 Fed. Reg. 37232 (May 6, 2024).

[14] U.S. Senate Committee on Health, Education, Labor and Pensions. News Release, “Ranking Member Cassidy Releases Statement on FDA Proposed Laboratory Developed Tests Rule” (Sept. 29, 2023). Earlier this year, Sen. Cassidy also requested information from stakeholders on regulation of clinical tests, observing that “[s]ince 1976, there have been no significant reforms to the regulation of clinical tests, even as new, innovative tests are being used in health care settings.” U.S. Senate Committee on Health, Education, Labor and Pensions News Release, “Ranking Member Cassidy Seeks Information from Stakeholders on Regulation of Clinical Tests” (March 13, 2024).

[15] U.S. Senate Committee on Health, Education, Labor and Pensions, News Release, “Ranking Member Cassidy Rebukes Biden Admin Attempt to Dramatically Increase FDA Authority over Laboratory Developed Tests” (Apr. 29, 2024).

[16] U.S. House Committee on Energy and Commerce Press Release, “Chair Rodgers Statement on FDA LDT Rule” (Apr. 29, 2024).

[17] U.S. House Committee on Energy and Commerce Press Release, “Health Subcommittee Hearing: ‘Evaluating Approaches to Diagnostic Test Regulation and the Impact of the FDA’s Proposed Rule’” (Mar. 21, 2024).

[18] The VALID Act was approved by the Senate HELP Committee in 2022, but ultimately failed to become law. See U.S. Senate Committee on Health, Education, Labor and Pensions. News Release, “Murray Leads HELP Committee in Advancing Historic Bipartisan Bills to Lower Drug Costs, Strengthen Workers’ Retirement Security, More” (June 14, 2022); “Healthcare groups urge Congress to pass diagnostic testing reform before year’s end,” MedTech Dive (Dec. 13, 2022).

[19] See H.R. 2369, 118th Cong. (2023).

[20] See, e.g., 89 Fed. Reg. at 37352-55, 37366-67, 37379-81; see also, e.g., “US lawmakers again propose diagnostics reform bill,” Regulatory Focus (Mar. 30, 2023); “Stakeholders continue push for VALID Act in wake of FDA’s proposed LDT rule,” Regulatory Focus (Oct. 6, 2023).

[21] See Office of Information and Regulatory Affairs, “OIRA Conclusion of EO 12866 Regulatory Review; RIN 0910-AI85.”

The following Gibson Dunn lawyers assisted in preparing this update: Katlin McKelvie and Carlo Felizardo.

Gustav W. Eyler – Washington, D.C. (+1 202.955.8610, geyler@gibsondunn.com)
Katlin McKelvie – Washington, D.C. (+1 202.955.8526, kmckelvie@gibsondunn.com)
John D. W. Partridge – Denver (+1 303.298.5931, jpartridge@gibsondunn.com)
Jonathan M. Phillips – Washington, D.C. (+1 202.887.3546, jphillips@gibsondunn.com)
Carlo Felizardo – Washington, D.C. (+1 202.955.8278, cfelizardo@gibsondunn.com)

Gibson Dunn’s Workplace DEI Task Force aims to help our clients develop creative, practical, and lawful approaches to accomplish their DEI objectives following the Supreme Court’s decision in SFFA v. Harvard. Prior issues of our DEI Task Force Update can be found in our DEI Resource Center. Should you have questions about developments in this space or about your own DEI programs, please do not hesitate to reach out to any member of our DEI Task Force or the authors of this Update (listed below).

Key Developments:

On April 24, 2024, the Wisconsin Institute for Law & Liberty (WILL), a conservative non-profit organization, sent a letter to the American Bar Association (ABA) concerning its Judicial Clerkship Program and Judicial Intern Opportunity Program, claiming that these programs unlawfully use race as a criterion for selecting participants. The ABA’s Judicial Clerkship Program consists primarily of a conference that “introduces law students from diverse backgrounds . . . to judges and law clerks” and “informs and educates the students as to life-long benefits of a judicial clerkship.” Participating law schools identify “four to six law students who are from underrepresented communities of color” to send to the conference. The ABA’s Judicial Internship Opportunity Program offers opportunities for students who are members of traditionally underrepresented racial and ethnic groups in the legal profession to work with a judge over the summer. Applicants for this program must indicate how they qualify and may check boxes specifying their race, gender, socioeconomic status, sexual orientation, gender orientation, or disability status. WILL alleges that the criteria for both of these programs constitute unlawful racial quotas. In its letter, WILL cautioned the ABA that it will pursue legal action unless the ABA announces by April 30, 2024 that these programs will no longer consider race as an eligibility factor. As of May 7, 2024, WILL has not reported any subsequent legal action.

On April 25, 2024, the Office for Civil Rights (OCR) for the U.S. Department of Education opened an investigation into Western Kentucky University’s Athletics Minority Fellowship program, which offers four $2,000 undergraduate scholarships to students who are “underrepresented ethnic minorit[ies]” interested in athletic administration careers. The investigation responds to a complaint filed on September 16, 2023 by the Equal Protection Project (EPP) alleging that the program discriminates on the bases of race and national origin because white students are not eligible. The website for the program is no longer active, but EPP states that it “doesn’t matter [if the program is no longer operating] because the discriminatory bell cannot be unrung.” EPP further demands that the university create “a remedial plan to compensate students shut out of this scholarship.” EPP’s complaint also challenges the university’s Distinguished Minority Fellowship program, which provides $15,000 to graduate students who are “African American, American Indian/Alaskan Native, Native Hawaiian/Pacific Islander, two or more races or Hispanic/Latino.” OCR has indicated that there is already an ongoing investigation into that program.

On April 25, 2024, America First Legal (AFL), the conservative organization founded and run by former Trump policy advisor Stephen Miller, announced that it had filed a federal civil rights complaint with the EEOC against Shake Shack, Inc., alleging race and sex discrimination in violation of Title VII. AFL claims that Shake Shack discriminates on the basis of race and sex by unlawfully considering the protected characteristics of applicants and employees when making employment decisions. In support of these allegations, AFL cites the company’s May 2023 Proxy Statement, in which Shake Shack outlined its “5-Year Diversity Targets” that concentrate on women and people of color. Specifically, Shake Shack set a goal for 50% of its leadership roles to be occupied by people of color by the end of 2025, and also mandated that at least two underrepresented minorities, women, or people of color be interviewed when hiring for leadership positions. AFL highlights Shake Shack’s June 2023 update on its DEI goals, as well, where the company cited a 33% increase in the representation of women and an 18% increase in people of color in leadership positions since establishing its 2025 diversity goals. AFL also sent a cease and desist letter to Shake Shack’s CEO and Board of Directors demanding that the company end its allegedly discriminatory employment practices.

As state lawmakers wrap up a busy legislative session, several states have passed bills seeking to promote DEI. On April 17, 2024, Virginia’s legislature enacted House Bill 1404, which establishes the Small SWaM (Small, Women-owned and Minority) Business Procurement Enhancement Program. The program fosters “initiatives to enhance the development of small businesses, microbusinesses, women-owned businesses, [and] minority-owned businesses” by supporting procurement opportunities for SWaM businesses participating in state-funded projects. On March 25, 2024, Washington’s legislature enacted House Bill 1377, which requires continuing education providers to align their content with the state cultural competency and DEI standards. And Maryland’s legislature has enacted two bills: Senate Bill 205, which requires at least one member of the Board of Regents of the University System of Maryland to be a graduate of a historically Black college or university in the state; and House Bill 1212, which establishes a DEI director for the State Retirement and Pension System.

Media Coverage and Commentary:

Below is a selection of recent media coverage and commentary on these issues:

New York Times, “What to Know About State Laws That Limit or Ban D.E.I. Efforts at Colleges” (April 21): The Times’ Anna Betts reports on recent efforts by Republican state lawmakers to roll back college diversity, equity, and inclusion initiatives. Betts explains that proponents of on-campus DEI policies and programs cite their importance in reversing decades of exclusion, but critics argue that DEI programs leave out other groups and perpetuate “reverse racism.” Betts reports that, according to The Chronicle of Higher Education, state lawmakers critical of DEI initiatives have introduced 84 bills targeting publicly funded diversity programs and admissions practices since 2023. Twelve have been enacted into law and 13 are awaiting governors’ signatures. In certain states, including Florida and Texas, these laws have eliminated all DEI-related positions and programs at public universities. But in other states, Betts says, schools are “work[ing] around these laws” by “reintroducing their D.E.I. offices under different names, and rewriting requirements to eliminate words like ‘diversity’ and ‘equity.’”
Forbes, “EEOC And Investors Support Hello Alice’s Grants For Black Entrepreneurs” (April 24): Geri Stengel, president of diverse entrepreneurship consultancy firm Ventureneer, writes about the legal and financial supporters of Hello Alice, a fintech platform providing funding and AI-driven financial tools to small business owners. Some of Hello Alice’s grants are tailored to historically underserved and underfunded groups, including the Black, Latino, Native American, LGBTQ+, rural, urban, and veteran communities. Like Fearless Fund, a venture capital fund providing financing to businesses led by women of color, Hello Alice is currently fighting a lawsuit alleging that these grantmaking policies violate Section 1981, which prohibits consideration of race in contracting. Stengel notes that the EEOC has filed an amicus brief in support of Hello Alice, arguing that SFFA does not prohibit voluntary affirmative action programs in private investment. And although the lawsuit initially cost Hello Alice some investors and grant sponsors, Stengel writes that the organization recently closed its Series C funding round, allowing it to expand its financing offerings for small businesses.
Daily Labor Report, “NYC Settles White Executives’ Demotion Suit Over Diversity Push” (April 25): Three former New York City Department of Education executives have settled their race-discrimination suit against the city, writes Bloomberg’s Ufonobong Umanah. In the suit, Herrera v. New York Department of Education, the white female plaintiffs alleged that they were demoted and replaced with less-qualified Black employees. Previously, Judge Mary Kay Vyskocil of the United States District Court for the Southern District of New York had granted summary judgment to the city on the plaintiffs’ sex discrimination claims, but denied judgment on their race discrimination claims, based in part upon former Mayor Bill de Blasio’s testimony “that it was ‘a policy’ of his administration to consider race in staffing decisions because he wanted the racial composition of his administration to mirror the racial diversity of the City.” The parties settled for an undisclosed amount.
Washington Post, “Can this firm invest in only Black women? This case will decide.” (April 29): The Post’s Julian Mark reports on Fearless Fund’s ongoing work as the venture capital firm awaits the Eleventh Circuit’s decision in American Alliance for Equal Rights v. Fearless Fund Management, LLC. Mark notes that AAER’s lawsuit is seen by some as “an inflection point” for civil rights and racial equity. Mark reports that the lawsuit is taking a toll on Fearless Fund itself—founder Arian Simone said the firm hasn’t had a closing since AAER filed its complaint in August 2023, although its portfolio remains “extremely healthy.” Simone told Mark that the exceptionality of Fearless Fund’s success in an industry dominated by white men only underscores the importance of its mission. “I would love a world that was equitable, where everybody received their fair portion,” Simone said. “If we lived in that world, I’d be fine—I can stop the Fearless Fund. But we don’t live in that world.” (Gibson Dunn represents the Fearless Fund in the litigation.)
Daily Labor Report, “DeSantis Takes Aim Again at Workplace DEI Despite Court Loss” (May 2): Bloomberg’s Chris Marr reports on Florida Governor Ron DeSantis’s May 2 comments about workplace diversity training. During a press conference, Governor DeSantis said that mandatory training sessions on inherent racial and gender bias can create a hostile work environment under existing state law. The governor also indicated that he plans to address the issue with administrative action. These statements come two months after the Eleventh Circuit affirmed a district court’s order preliminarily enjoining operation of Florida’s “Stop W.O.K.E. Act” in Honeyfund.com, Inc. v. DeSantis, — F.4th —, 2024 WL 909379 (11th Cir. Mar. 4, 2024), holding that the law “exceeds the bounds of the First Amendment” by “target[ing] speech based on its content” and thus “penaliz[ing] certain viewpoints.” But, as Marr reports, the governor maintains “that current Florida civil rights laws prohibit[] some of this racist training that is being done and imposed under the rubric of D, E, and I.”
Law360, “EEOC ‘Up For A Fight’ As High Court Title VII Test Takes Shape” (May 2): Law360’s Anne Cullen reports on a recent amicus brief filed by the EEOC in which the Commission argues that courts should apply the Supreme Court’s holding in Muldrow v. St. Louis—that employees alleging discrimination under Title VII need not show they faced significant harm to state a viable claim—to suits under the Americans with Disabilities Act (ADA). The case in which the EEOC filed its brief, Scheer v. Sisters of Charity of Leavenworth Health System, Inc. (No. 24-1055, 10th Cir.), is an appeal of the district court’s grant of summary judgment to the employer. In Scheer, the plaintiff was required to attend mandatory mental health treatment after expressing suicidal ideation but was later terminated after she refused treatment and would not sign a release of liability. The court held that the plaintiff had not shown that mandatory treatment constituted an adverse employment action under the ADA. Now, the Commission is taking the position that Muldrow abrogated the prior adverse-employment-action test in all workplace disputes, not just those under Title VII, and that the new, lower standard would make counseling referrals actionable. Cullen reports that this position “proved divisive internally,” with two of the five Commissioners voting not to file the brief in Scheer. Jason Schwartz, Gibson Dunn partner and co-chair of the firm’s Labor & Employment group, told Cullen that the Commission’s brief is an “overreading” of Muldrow: “It’s like they took the Play-Doh or Silly Putty and tried to stretch it as far as possible. It’s a super broad reading of Muldrow, broader than the Supreme Court intended, and certainly a reading that is going to encourage much more litigation.”

Case Updates:

Below is a list of updates in new and pending cases:

1. Contracting claims under Section 1981, the U.S. Constitution, and other statutes:

Crystal Bolduc v. Amazon.com Inc., No. 4:22-cv-615-ALM (E.D. Tex. Jul. 20, 2022): On July 20, 2022, AFL filed a putative federal class action lawsuit on behalf of a white plaintiff who sought to become an Amazon delivery service provider (DSP), alleging race discrimination in violation of Section 1981 in Amazon’s supplier-diversity initiatives, including a program extending $10,000 grants to Amazon delivery service providers allegedly based in part on race.
- Latest update: On April 25, 2024, the court partially granted Amazon’s motion to dismiss and dismissed the case without prejudice. The court found that Bolduc lacked Article III standing to sue because she never applied to Amazon’s DSP program and thus has suffered no actual or imminent injury. Although Bolduc argued that she was deterred from applying because of the allegedly discriminatory grant, the court explained that a plaintiff must submit to a policy before bringing an action to challenge it. The court concluded that “Bolduc falls outside the class of individuals potentially suffering a direct and personal injury: DSP owners who have been denied any contractual benefit due to their race.” Because the issue of standing was sufficient to dismiss the case, the court did not consider whether Bolduc had failed to state a claim under Section 1981 as Amazon argued in its motion to dismiss. On April 26, 2024, Bolduc filed a notice of appeal.
Poer v. Jefferson Cty. Comm’n , No. 22-11401 (11th Cir. May 1, 2024): In August 2019, Angela Poer filed suit in the Northern District of Alabama alleging that the Jefferson County Commission discriminated against her based on her race in violation of Title VII and Sections 1981 and 1983 by refusing to grant her transfer request and firing her. Poer argued that her boss, a Black woman, created a hostile work environment and denied her transfer request because of her animus against white people. The district court granted the Commission’s motion for summary judgment, finding that no direct evidence supported Poer’s racial discrimination claims and any circumstantial evidence was insufficient to create a reasonable inference that her termination was racially motivated. Poer appealed.
- Latest update: On May 1, 2024, the Eleventh Circuit affirmed the district court’s grant of summary judgment in favor of the Commission. The court found that the Commission offered several legitimate, non-discriminatory explanations for terminating Poer, including multiple performance issues caused by her repeated absences and mishandling of money. The court rejected Poer’s argument that her boss’s alleged racially discriminatory remarks alone were sufficient to preclude summary judgment, finding that Poer failed to tie any discriminatory comments to the decisionmakers who actually fired her.
Valencia AG, LLC v. New York State Off. of Cannabis Mgmt. et al., No. 5:24-cv-116-GTS (N.D.N.Y. Jan. 24, 2024): On January 24, 2024, Valencia AG, a cannabis company owned by white men, sued the New York State Office of Cannabis Management for discrimination, alleging that New York’s Cannabis Law and implementing regulations favored minority-owned and women-owned businesses. The regulations include goals to promote “social & economic equity” (“SEE”) applicants, which the plaintiff claims violate the Fourteenth Amendment’s Equal Protection Clause and Section 1983. On March 13, 2024, the plaintiff’s new counsel, Pacific Legal Foundation, filed an amended complaint, naming only two New York state officials as defendants in their official capacity. The plaintiff sought a permanent injunction against the regulations and a declaration that the use of race and sex in the New York Cannabis Law violates the Fourteenth Amendment.
- Latest update: On April 24, 2024, the defendants moved to dismiss the amended complaint, arguing that the plaintiff lacks standing because no injury or imminent harm warrants such broad relief. The defendants explained that the plaintiff’s “position in the queue [for a New York microbusiness cannabis license] is too low to be considered even if no minority- or women-owned SEE applicants had even applied.” The defendants also argued that the plaintiff failed to state a plausible claim under the Equal Protection Clause. The plaintiff’s response is due May 15, 2024.

2. Employment discrimination and related claims:

Cooper v. The Office of the Commissioner of Baseball et al., No. 1:24-cv-03118 (S.D.N.Y Apr. 24, 2024): On April 24, 2024, a former minor league baseball umpire sued Major League Baseball, alleging that he was fired after he accused a female umpire of harassing him and using homophobic slurs. The complaint alleges that MLB implemented an “illegal diversity quota requiring that women be promoted regardless of merit,” which the plaintiff claims emboldened the female umpire to make statements to him and other male umpires that, “I’m a woman and can get away with anything,” and that “MLB has to hire females, they won’t get rid of me unless I quit.”
- Latest update: The docket does not reflect that MLB has been served.

The following Gibson Dunn attorneys assisted in preparing this client update: Jason Schwartz, Mylan Denerstein, Blaine Evanson, Molly Senger, Zakiyyah Salim-Williams, Matt Gregory, Zoë Klein, Mollie Reiss, Jenna Voronov, Alana Bevan, Marquan Robertson, Elizabeth Penava, Skylar Drefcinski, Mary Lindsay Krebs, David Offit, Lauren Meyer, Kameron Mitchell, Maura Carey, and Jayee Malwankar.

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 Labor and Employment practice group, or the following practice leaders and authors:

Jason C. Schwartz – Partner & Co-Chair, Labor & Employment Group
Washington, D.C. (+1 202-955-8242, jschwartz@gibsondunn.com)

Katherine V.A. Smith – Partner & Co-Chair, Labor & Employment Group
Los Angeles (+1 213-229-7107, ksmith@gibsondunn.com)

Mylan L. Denerstein – Partner & Co-Chair, Public Policy Group
New York (+1 212-351-3850, mdenerstein@gibsondunn.com)

Zakiyyah T. Salim-Williams – Partner & Chief Diversity Officer
Washington, D.C. (+1 202-955-8503, zswilliams@gibsondunn.com)

Molly T. Senger – Partner, Labor & Employment Group
Washington, D.C. (+1 202-955-8571, msenger@gibsondunn.com)

Blaine H. Evanson – Partner, Appellate & Constitutional Law Group
Orange County (+1 949-451-3805, bevanson@gibsondunn.com)

Jane Love and Robert Trenchard are the authors of “Double-Patenting Ruling Shows Terminal Disclaimers’ Value” [PDF] published by Law360 on May 8, 2024.

This update summarises the proposed scoping changes, the transitional arrangements and the implications for Excluded Companies and their shareholders and other parties considering a transaction involving an Excluded Company.

EXECUTIVE SUMMARY

On 24 April 2024, the UK Panel on Takeovers and Mergers (the primary regulator in the UK of takeovers of public companies) (the “Panel”) published PCP 2024/1, a Consultation Paper proposing changes to the types of companies to which the City Code on Takeovers and Mergers (the “Takeover Code”) applies.[1]

The proposed changes published by the Code Committee of the Panel (the “Code Committee”) largely narrow the scope of application of the Takeover Code to companies registered in the UK or any of the Crown Dependencies[2] and which currently are UK-listed or listed on a stock exchange of a Crown Dependency (or were so listed at any time in the three years before the company becomes subject of a Takeover Code-regulated offer or event).

The Panel pre-consulted with a number of potentially impacted market participants and industry bodies in devising the proposed changes. It is expected that the changes will be implemented largely as set out in the consultation paper. The likely implementation date will be in Q4 2024.

If the changes are implemented as proposed, a number of companies which are currently subject to the jurisdiction of the Panel and the Takeover Code will fall outside of their jurisdiction (“Excluded Companies”) and consequently companies and shareholders can expect to lose certain protections and benefits currently afforded to target companies under the Takeover Code. The Panel proposes to introduce a three-year transition period from the date of implementation to allow Excluded Companies to consider and implement (if so desired) alternative arrangements to address the loss of protections which will arise as a result of becoming an Excluded Company.

Effective Financial Markets Regulation
1. The key principles for good financial market regulators across the international regulatory landscape would generally expect to include the following: engendering in the regulated community; being robust including having an effective enforcement mechanism in place; being proportionate and fair; ensuring all relevant stakeholders understand the regulator’s approach and having a keen and active understanding of the relevant financial services markets[3].
2. The proposed changes by the Panel is an exemplar of these principles in action and yet another instance where the Panel has demonstrate its pragmatic and agile approach to takeover regulation.
3. The Panel is desirous of ensuring that its jurisdictional rules (being the gateway into the Code and regulation by the Panel – both of which are often seen by those unfamiliar with UK public takeover regulation as being a challenge to navigate – unusually light on black-letter law and heavy on the principles-based approach of regulation) are “clear, certain and objective”.
4. Further, having undertaken a thorough pre-consultation exercise including with the key UK government ministry, financial services regulator, stock exchange and operators of secondary trading and fund-raising platforms, the Panel is mindful of not over-reaching nor imposing regulatory burdens which are not “appropriate or proportionate for pre-listing, growth phase companies”[4] nor being excessively protective in relation to certain companies post-listing.
5. Post-Brexit, the UK has been on a mission to “cement its position as a leader in science, research and innovation[5]“ by supporting and encouraging growth companies and bolstering its position as a global trading centre in particular by making UK’s listing regime more accessible, effective and competitive. The proposed changes of the Panel, which tighten its jurisdictional remit, are aligned with these broader policy objectives.
History … Expansion & Contraction
1. In its 56 years of operation the scope and remit of Code has seen many changes. The Code was originally drafted with quoted companies only in mind but gradually expanded to cover certain unquoted public companies (i.e. entities with or set up with a view to extending offers to large numbers of shareholders) and even certain transactions involving private companies (or those who had been recently quoted or public). The types of transactions which fall within the remit of the Code has also seen an expansion over the years to address new and novel structures that market participants have implemented to secure effective direct or indirect control of Code companies.
2. The Panel however has also been mindful to ensure that its stellar reputation and track record in relation to enforcement is upheld. In making this assessment the Panel has naturally been cognizant of its modest resources comprising a small (but effective) executive team of permanent and seconded staff. Accordingly, a cautious and risk-based approach has been adopted before extending the arm of the Panel/ Code to companies outside of its primary remit (being regulation of UK listed companies) to, for example, companies listed on overseas exchanges and/or whose management is outside of the comfortable (and proportionate) reach of the Panel.
3. As part of the expansionist period, in 2005[6], as a result of implementation of the EU Takeovers Directive in the UK, the Panel was required to take on “shared jurisdiction” of companies which were UK registered but not listed in the EU or were EU registered but listed in the UK. In 2013[7], the Panel changed its rules on the application of the “residency test” (see 4.c, “UK resident: What does it mean” in section 4 below) in determining whether a company was in scope and removed this additional requirement in respect of certain types of companies thus potentially expanding the numbers of companies/ transactions within its regulatory scope.
4. However, in recent years, the Code has seen a narrowing of the scope of companies within the remit of the Panel. In 2018[8], in the light of the UK’s withdrawal from the EU, the Panel took the view that it was appropriate (though not a mandated outcome) to cease to have the so-called “shared jurisdiction” with relevant EU members states. At that time, it was estimated circa x40 companies ceased to be regulated by the Panel.
5. With these latest set of proposed changes, once again, there will be a number of companies which will cease to fall within scope of the Code. It is not practicable to identify the number of Code companies which will cease to be in scope as such but upon review of data between 2017 and 2024 the Code Committee estimates a reduction of the average number of transactions which it regulates from 76 to 72.
Which companies will be in scope?
1. Primary scoping rule – So what type of companies is the Panel proposing to regulate going forward? If the changes are implemented, the Panel would regulate companies which:
  1. are registered in the UK or in any one of the Crown Dependencies (a “Code Jurisdiction”); AND
  2. whose securities are admitted to trading on:
    1. a UK regulated market[9] – for example the Main Market of the London Stock Exchange or the Aquis Stock Exchange (AQSE).
    2. a UK multilateral trading facility[10] – for example the AIM market operated by the London Stock Exchange and the Aquis Growth Market; or
    3. a stock exchange in any one of the Crown Dependencies – for example The International Stock Exchange or “TISE”.
  We refer to companies with securities admitted to trading in any of the categories in 1. – 3. above as “UK-listed”. As currently is the case, the Code will not apply to a company which is incorporated in or has its registered office outside the UK or one of the Crown Dependencies.
2. UK-Listed: What it does not cover – Accordingly, companies with securities trading on:
  (i) a matched bargain facility such as JP Jenkins or Asset Match ;(ii) a multilateral system or a platform such as the proposed new Private Intermittent Securities and Capital Exchange System (PISCES);(iii) a private markets (such as TISE Private Markets ); or(iv) a secondary market of a crowdfunding platform such as Seedrs Secondary Market or Crowdcube,will be outside of scope.
3. Three-year secondary scoping rule – In addition, companies which are registered in a Code Jurisdiction will also be in scope of the Code if they were UK-listed at any time during the three years prior to the date of announcement of an offer or possible offer (or some other Code-relevant transaction) – the “relevant date”. The retention of a “run-off” period is consistent with the current approach under the Code (albeit for a shorter period than the current 10 year run-off period – (see 4.b, ”Private companies” in section 4 below) and is designed to address the situation where for example a company has been subject of a takeover offer, been delisted but there remains a minority which chose not to accept the offer and remain as shareholders – some level of protection is considered appropriate for this cohort.
Which companies currently in scope will become out of scope?
1. Public companies – Currently, the Code also applies to public companies registered in a Code Jurisdiction if they are “UK resident”, regardless of whether the company’s securities are UK-listed or traded on an overseas market (e.g. NASDAQ or NYSE) or traded using a matched bargain facility.
2. Private companies – Currently, the Code also applies to private companies registered in a Code jurisdiction, which are “UK resident” but only if: (a) they were UK-listed at any time during the 10 years prior to the relevant date; (b) dealings in the company’s securities were published on a regular basis for a continuous period of at least six months in the 10 years prior to the relevant date [NB: this would capture for example matched bargain facilities such a JP Jenkins]; (c) any of the company’s securities were subject to a marketing arrangement at any time during the 10 years prior to the relevant date; or (d) the company had filed a prospectus with a relevant authority in any one Code Jurisdiction during the 10 years prior to the relevant date (together the “10 year look-back rules”).
3. “UK resident”: What does it mean? – One of the key drivers behind the proposed changes is the desire by the Code Committee to move away from a jurisdictional test which relies on “UK residency”. For Code purposes, a company will be treated as being “UK resident” if the place of central management and control of a company is in one the Code Jurisdictions. Of note, this is not a tax or other regulatory residency test. The Panel has applied its own test of “central management and control” which it has developed and indeed simplified over time. In the first instance, residency is tested against a quantitative test of where the majority of the board of a company reside but the Panel reserves the discretion to assess more qualitative factors (e.g. giving consideration to the specific roles of the members of the board) depending on the facts and the outcome of the quantitative test. By its nature, the “residency” of a company for Code purposes can change over time depending on where the majority of the board reside and indeed many companies have deliberately ensured that the majority of their board are not “UK resident” in order to avoid falling within the scope of the Code and regulation of the Panel. One of the challenges of the UK residency test (in addition to its more subjective and potentially shifting nature) is that it is “often not possible to ascertain from publicly available information whether at any point in time an unlisted public company [i.e. a non-UK Listed company] or a private company satisfies the residency test”[11]. For example, a UK registered which is listed on an overseas exchange may not be required to disclose and/or update its “UK residency” and relate Code status under applicable exchange and securities law or regulatory requirements. The Panel is no longer comfortable with this position and is desirous of putting in place a regime which allows both companies and market participants to reach an objective determination as to whether a company is or is not a Code company.
4. UK residency test removed – Accordingly, the proposed changes involve the removal of the “UK residency” test scoping limb and also materially modify the 10-year look back rule replacing the latter simply with a three year look-back rule for UK-listed companies only.
5. Excluded Companies – As a result of these changes, the following companies (each being an Excluded Company) will no longer be subject to the jurisdiction of the Code:
  1. a public or private company which was UK-listed more than three years prior to the relevant date;
  2. a public or private company whose securities are, or were previously, traded solely on an overseas market;
  3. a public or private company whose securities are, or were previously, traded using a matched bargain facility such as JP Jenkins or Asset Match;
  4. any other “unlisted” public company; and
  5. a private company which filed a prospectus at any time during the 10 years prior to the relevant date,
  unless the company had been UK-listed at any time during the three years prior to the relevant date.
Transitional arrangements for companies currently in scope which will become Excluded Companies
1. The Code Committee considers that it is appropriate that Excluded Companies – being companies currently within (or potentially within the scope of the Code – to be given a period of time to adjust to the new regime. These will cover public companies referred to in paragraph ‎a above and private companies described in paragraph ‎4.b above.
2. These companies which will be referred to as “transition companies” will remain within the scope of the Code for three years from the date of implementation of the new scoping rules.
3. The Code Committee has summarised out in its consultation paper the proposed transitional arrangements (see Appendix C) and has also provided helpful infographics to identify if a company is a “transition company” on the implementation date (see Appendix D) and if it will be a transition company in respect of a specific transaction (see Appendix E).
4. The Panel expects transition companies to use this period to consider whether it is appropriate to implement alternative arrangements in the light of their pending exclusion from the Code. As noted above, the Code provides a number of protections for companies which find themselves in receipt of a potential takeover offer (target companies) and their shareholders. These include but are not limited to enhanced disclosure of interests and dealings when a company is in play, rules requiring equivalent treatment of all shareholders, the requirement for a person and their “concert parties” who obtains or consolidates control to make a “mandatory offer” on similar terms.
5. Alternative arrangements (which will likely come with cost) may include a transition company:
  1. seeking admission of its securities to trading on a relevant UK market (e.g. a secondary listing) in order to become subject to the jurisdiction of the Panel;
  2. seeking admission of its securities to trading on another market in order to become subject to regulation of a comparable securities regulator;
  3. amending its Articles of Association to incorporate new provisions which are similar to or based upon certain ‘key’ provisions and protections of the Code; and/or
  4. implementing arrangements to facilitate an orderly exit of shareholders who do not wish to remain holders in a company without the protections granted by the Code.
6. If the transition company proposed to entrench new “Code-like” provisions into the contract with its members (i.e. its Articles of Association), it will be for the company to assess (ideally taking into account the views of investors and other relevant stakeholders) which Code provisions they consider appropriate to incorporate. Amended governance documents will however need to be approved by shareholders. Shareholders will need to understand that whilst their new articles of association may include certain Code-like or Code-inspired provisions, the Panel will not have jurisdiction to regulate enforcement of these provisions.
7. Excluded Companies (and companies who have previously publicly disclosed the potential application of the Code depending on whether they satisfy the UK resident test) including those traded on overseas exchanges, will need to consider whether and when to disclose to shareholders that they will no longer become subject to (or potentially subject to) the jurisdiction of the Code and Panel and the protections to shareholders that this affords. This will be dictated in part by reference to the (overseas) exchange and securities regulation applicable to such companies and the nature of any prior disclosures made to shareholders/ the public.
Implications
1. For Excluded Companies
  Directors of these UK registered entities have a duty to promote the success of the company for the benefit of its shareholders taking into account, among other things, the interests of its employees. Companies which will become an Excluded Company should start to give early consideration about what alternative options the company should consider implementing if any in the light of the loss of protections both for the company (in the event it becomes subject of an offer), its shareholders and (to a lesser degree, its employees) when it becomes an Excluded Company. At the least, it should start to prepare to engage with its shareholder based on these issues
2. For Shareholders of Excluded Companies
  Shareholders of companies who will fall outside of scope, as part of their stewardship duties and taking account (where relevant e.g. in the case of institutional investors or sovereigns) their fiduciary duties to their ultimate beneficiaries, they should start to give consideration to what are the key shareholder protections/regulatory expectations they have as a result of their investee company being a Code regulated company and what protections if any they consider critical to preserve going forward. Armed with this analysis and assessment they can then prepare to pro-actively engage at an early stage with investee companies which will fall to become an Excluded Company and/or to actively participate in any outreach and engagement that these companies may have with shareholders going forward during their transition periods. Is the “mandatory offer” concept a key protection from “effective”/ 30%+ controllers? How much comfort is taken from the “rule against frustrating action”?
3. For Parties Interested in an Excluded Company
  Parties engaging with Code companies, whether with a view to carrying out a takeover offer, other Code regulated transaction or indeed even seeking to transact with a Code company which is “in play” (a “Code Transaction”), can find compliance with the Code’s target-company/target-shareholder friendly regime somewhat costly and burdensome in particular, if this is in addition to compliance with overseas exchange and securities law requirements which apply to that company in parallel. The prospect of undertaking a transaction outside of the regime of the Code may indeed be welcome. Whilst we are some years away from the end of the transitional period for Excluded Companies and these companies falling out of scope of the Code, third parties who may be considering a Code Transaction closer to that end date, should be mindful of that date and/or of any alternative arrangements that the Excluded Company may implement when assessing timing (e.g. waiting till post the expiry of the transitional period) and the structure of any possible transaction.
Next Steps & Timing
1. Comments to the Consultation Paper should be sent to the Code Committee in writing or by email[12] by 31 July 2024.
2. The Code Committee intends to publish a response statement to the consultation in Autumn 2024 and the expected implementation date of the changes is circa one month after publication of this response document.
3. As noted above, the transition period for Excluded Companies to prepare for exclusion is three years from the implementation date.

__________

[1] PCP 2024/1 – Companies to which the Takeover Code applies

[2] These are the Isle of Man, Guernsey and Jersey

[3] ICAEW Principles For Good Financial Regulators

[4] Paragraph 2.20 of PCP 2024/1

[5] UK Government Innovation Strategy Statement Nov 2023

[6] See PCP2005/5 – The implementation of the Takeovers Directive.

[7] See PCP2012/3 – Companies subject to the Takeover Code

[8] See PCP 2018/2 – The United Kingdom’s withdrawal from the European Union

[9] As defined in paragraph 13(a) of Article 2(1) of Regulation (EU) No 600/2014 on markets in financial instruments (“UK MiFIR”)

[10] As defined in paragraph (14A) of Article 2(1) of UK MiFIR

[11] Paragraph 2.14 of PCP 2024/1

[12] Email to supportgroup@thetakeoverpanel.org.uk

The following Gibson Dunn lawyer prepared this update: Selina Sagayam.

If you have any questions on the impact of the proposed changes, including application of the transitional arrangements, or are seeking advice on assessing and implementing alternative arrangements for companies which will come out of scope of the Code, we are happy to assist.

For questions about this alert or other UK public M&A or capital market queries, contact the Gibson Dunn lawyer with whom you usually work, the author of this alert or these public listed company and capital markets contacts in London:

Selina S. Sagayam (+44 20 7071 4263, ssagayam@gibsondunn.com)

Chris Haynes (+44 20 7071 4238, chaynes@gibsondunn.com)

Steve Thierbach (+44 20 7071 4235, sthierbach@gibsondunn.com)

For US securities regulatory queries, including the impact of the proposal on US transition companies, please contact:

James J. Moloney – Orange County, CA (+1 949.451.4343, jmoloney@gibsondunn.com)

Public companies have used spin-off transactions for many years to separate a business unit that is no longer a strategic fit with the businesses they wish to retain or when a business unit within the company’s structure would receive a higher valuation as an independent company.

Our presenters explain the basic structure of spin-off transactions and discuss the pros and cons as compared to other separation alternatives, including carve-out IPOs. They examine these issues from various legal perspectives, including corporate, tax and capital markets. The presenters also discuss strategies for avoiding and solving the problems that most frequently arise in spin-off transactions.

PANELISTS:

Hillary Holmes is co-chair of the firm’s Capital Markets practice group and a member of the firm’s Securities Regulation & Corporate Governance, Mergers & Acquisitions, ESG, and Energy & Infrastructure Practice Groups. Hillary also serves as co-partner-in-charge of the Houston office and as a member the firm’s Executive Committee. Hillary advises corporations, investment banks and institutional investors on long-term and strategic capital raising. She regularly counsels companies on securities laws, corporate governance and ESG issues. She also counsels boards of directors, special committees and financial advisors in M&A transactions, take privates and complex situations.

Andrew L. Fabens is a partner in the New York office of Gibson, Dunn & Crutcher. He serves as co-partner in charge of the New York office, co-chair of Gibson Dunn’s Capital Markets Practice Group and is a member of Gibson Dunn’s Securities Regulation and Corporate Governance Practice Group. Mr. Fabens advises companies on long-term and strategic capital planning, disclosure and reporting obligations under U.S. federal securities laws, corporate governance issues and stock exchange listing obligations. He represents issuers and underwriters in public and private corporate finance transactions, both in the United States and internationally. His experience encompasses initial public offerings, follow-on equity offerings, investment grade, high-yield and convertible debt offerings and offerings of preferred, hybrid and derivative securities. In addition, he regularly advises companies and investment banks on corporate and securities law issues, including M&A financing, spinoff transactions and liability management programs.

Saee Muzumdar is a partner in the New York office of Gibson, Dunn & Crutcher and Co-Chair of the firm’s Mergers and Acquisitions Practice Group. Ms. Muzumdar is a corporate transactional lawyer whose practice includes representing both strategic companies and private equity clients (including their portfolio companies) in connection with all aspects of their domestic and cross-border M&A activities and general corporate counseling. She has significant experience with acquisitions and divestitures of public and private entities (including both negotiated transactions and contested takeovers), venture capital investments, proxy contests, tender and exchange offers, recapitalizations, leveraged buyouts, spinoffs, carveouts, joint ventures and other complex corporate transactions. In addition, Ms. Muzumdar has represented a number of major investment banks as financial advisors in M&A transactions and financial institutions in connection with their investment activities.

Pamela Lawrence Endreny is a partner in the New York office of Gibson, Dunn & Crutcher. Ms. Endreny represents clients in a broad range of U.S. and international tax matters. Ms. Endreny’s experience includes mergers and acquisitions, spin-offs, joint ventures, financings, restructurings and capital markets transactions. She has obtained private letter rulings from the Internal Revenue Service on tax-free spin-offs and other corporate transactions. Ms. Endreny is a member of the Executive Committee of the New York State Bar Association Tax Section.

Malakeh Hijazi is an associate in the Houston office of Gibson, Dunn & Crutcher, where she currently practices with the firm’s Capital Markets and Securities Regulation and Corporate Governance practice groups. She represents public and private businesses in a broad range of corporate and securities matters. Malakeh represents issuers and investment banking firms in both equity and debt offerings. Her practice also includes general corporate concerns, including Exchange Act reporting and corporate governance.

MCLE CREDIT INFORMATION:

This program has been approved for credit in accordance with the requirements of the New York State Continuing Legal Education Board for a maximum of 1.0 credit hour, of which 1.0 credit hour may be applied toward the areas of professional practice requirement. This course is approved for transitional/non-transitional credit.

Attorneys seeking New York credit must obtain an Affirmation Form prior to watching the archived version of this webcast. Please contact CLE@gibsondunn.com to request the MCLE form.

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California attorneys may claim “self-study” credit for viewing the archived version of this webcast. No certificate of attendance is required for California “self-study” credit.

Naranjo v. Spectrum Security Services, Inc., S279397 – Decided May 6, 2024

The California Supreme Court held today that an employer is not subject to statutory penalties for providing incomplete or inaccurate wage statements if it reasonably and in good faith believed the statements were accurate.

“[A]n employer’s objectively reasonable, good faith belief that it has provided employees with adequate wage statements precludes an award of penalties under section 226.”

Justice Kruger, writing for the Court

Background:

California Labor Code section 226 requires employers to provide detailed wage statements to their employees. Employees can seek statutory penalties if they are injured “as a result of a knowing and intentional failure by an employer” to comply with the wage-statement requirement. (Lab. Code, § 226, subd. (e)(1).)

Gustavo Naranjo, a security guard for Spectrum Security Services, brought a putative class action alleging that Spectrum had violated section 226 by failing to report premium amounts due to employees who missed meal breaks. After an initial appeal in which the California Supreme Court clarified that section 226 required wage statements to list premium pay for missed meal periods (Naranjo v. Spectrum Security Services, Inc. (2022) 13 Cal.5th 93), the case was remanded to the Court of Appeal to determine whether Spectrum’s failure to list such premium pay on its wage statement was “knowing and intentional,” such that penalties could be imposed under section 226. The Court of Appeal held that because Spectrum had a reasonable, good-faith belief at the time that its wage statements were accurate (based on uncertainty in the law before the California Supreme Court’s initial decision), the violation was not “knowing and intentional” and could not give rise to section 226 penalties.

The California Supreme Court again granted review, this time to decide whether an employer knowingly and intentionally fails to comply with section 226 when it has a reasonable, good-faith belief that its wage statements complied with the statute.

Issue:

Can an employer be held liable for statutory penalties under Labor Code section 226 if it issues incomplete or inaccurate wage statements with a reasonable and good-faith (but incorrect) belief that the statements were compliant?

Court’s Holding:

No, because “an employer’s objectively reasonable, good faith belief that it has provided employees with adequate wage statements precludes an award of penalties under section 226.”

What It Means:

This decision represents a significant victory for California’s employers, who often face substantial liability for wage-statement violations predicated on other alleged violations of the Labor Code. After today’s decision, an employer will not be liable for penalties under section 226 for wage-statement violations if it had a reasonable and good faith belief that its wage statements complied with the statute.
The Court noted that its holding was consistent with other provisions of the Labor Code that do not allow for statutory penalties where employers reasonably and in good faith believe that they are complying with the law. Reading the Labor Code as a whole to adopt a consistent scheme on the issue of when penalties may be assessed makes sense, the Court reasoned, because claims related to deficient wage statements “are more typically raised as derivative claims of other Labor Code” sections.
Because a good-faith defense based on a misunderstanding of law under section 226 is available only “where the employer’s obligations are genuinely uncertain,” the defense will not be available to companies that do not comply with well-established law. But in cases where the law is unsettled, employers will be able to use that uncertainty as a defense to section 226 penalties.

The Court’s opinion is available here.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding developments at the California Supreme Court. Please feel free to contact the following practice leaders:

Appellate and Constitutional Law Practice

Thomas H. Dupree Jr. +1 202.955.8547 tdupree@gibsondunn.com	Allyson N. Ho +1 214.698.3233 aho@gibsondunn.com	Julian W. Poon +1 213.229.7758 jpoon@gibsondunn.com
Lucas C. Townsend +1 202.887.3731 ltownsend@gibsondunn.com	Bradley J. Hamburger +1 213.229.7658 bhamburger@gibsondunn.com	Michael J. Holecek +1 213.229.7018 mholecek@gibsondunn.com

Related Practice: Labor and Employment

Jason C. Schwartz
+1 202.955.8242
jschwartz@gibsondunn.com

Katherine V.A. Smith
+1 213.229.7107
ksmith@gibsondunn.com

Jesse A. Cripps
+1 213.229.7792
jcripps@gibsondunn.com

Related Practice: Litigation

Theodore J. Boutrous, Jr.
+1 213.229.7804
tboutrous@gibsondunn.com

Theane Evangelis
+1 213.229.7726
tevangelis@gibsondunn.com