Cryptocurrency Archives

On October 25, 2021, the Dubai Financial Services Authority (“DFSA”) updated its Rulebook for “crypto” based investments by launching a regulatory framework for “Investment Tokens”. This framework follows, on the whole, the approach proposed in the DFSA’s “Consultation Paper No. 138 – Regulation of Security Tokens”, published in March 2021 (the “Consultation Paper”).

Peter Smith, Managing Director, Head of Strategy, Policy and Risk at the DFSA has noted that: “Creating an ecosystem for innovative firms to thrive in the UAE is a key priority for both the UAE and Dubai Governments, and the DFSA. Our consultation on Investment Tokens enabled us to understand what firms were looking for in a regulatory framework and introduce a regime that is relevant to the market. We look forward to receiving applications from interested firms and contributing to the ongoing growth of future-focused financial services in the DIFC.”[1]

What is an “Investment Token”?

An “Investment Token” is defined as either a “Security Token” or a “Derivative Token”[2]. Broadly speaking, these are:

a security (which includes, for example, a share, debenture or warrant) or derivative (an option or future) in the form of a cryptographically secured digital representation of rights and obligations that is issued, transferred and stored using Distributed Ledger Technology (“DLT”) or other similar technology; or
a cryptographically secured digital representation of rights and obligations that is issued, transferred and stored using DLT or other similar technology and: (i) confers rights and obligations that are substantially similar in nature to those conferred by a security or derivative; or (ii) has a substantially similar purpose or effect to a security or derivative.

However, importantly, the definition of “Investment Token” will not capture virtual assets which do not either confer rights and obligations substantially similar in nature to those conferred by a security or derivative, or have a substantially similar purpose or effect to a security or derivative. This means that key cryptocurrencies such as Bitcoin and Ethereum, as well as stablecoins such as Tether, will remain unregulated under the Investment Tokens regime.

Scope of framework

This regulatory framework applies to persons interested in marketing, issuing, trading or holding Investment Tokens in or from the Dubai International Financial Centre (“DIFC”). It also applies with respect to DFSA authorised firms wishing to undertake “financial services” relating to Investment Tokens. Such financial services would include (amongst other things) dealing in, advising on, or arranging transactions relating to, Investment Tokens, or managing discretionary portfolios or collective investment funds investing in Investment Tokens.

Approach taken by the DFSA

The approach taken by the DFSA has been to, rather than establish an entirely separate regime for Investment Tokens, bring these instruments within scope of the existing regime for “Investments”, subject to certain changes. The Consultation Paper noted that “in line with the approach adopted in the benchmarked jurisdictions, [the] aim is to ensure that the DFSA regime for regulating financial products and services will apply in an appropriate and robust manner to those tokens that [the DFSA considers] to be the same as, or sufficiently similar to, existing Investments to warrant regulation”.

The Consultation Paper proposed to do this through four means: (i) by making use of the existing regime for “Investments” as far as possible, whilst addressing specific risks associated with the tokens, especially technology risks; (ii) by not being too restrictive, so that the DFSA can accommodate the evolving nature of the underlying technologies that might drive tokenization of traditional financial products and services; (iii) by addressing risks to investor/customer communication and market integrity, and systemic risks, should they arise, where new technologies are used in the provision of financial products or services in or from the DIFC; and (iv) remaining true to the underlying key characteristics and attributes of regulated financial products and services, as far as practicable.

As noted at (i) above, the changes brought about on October 25, 2021 necessarily involved the addition of new requirements to address specific issues related to Investment Tokens. For instance, added requirements are imposed on firms providing financial services relating to Investment Tokens in Chapter 14 of the Conduct of Business Module of the DFSA Rulebook.

This sets out (amongst other things):

technology and governance requirements for firms operating facilities (trading venues) for Investment Tokens – for instance, they must: (i) ensure that any DLT application used by the facility operates on the basis of permissioned access, so that the operator is able to maintain adequate control of persons granted access; and (ii) have regard to industry best practices in developing their technology design and technology governance relating to DLT that is used by the facility;
rules relating to operators of facilities for Investment Tokens which permit direct access – for example, the operator must ensure that its operating rules clearly articulate: (i) the duties owed by the operator to the direct access member; (ii) the duties owed by the direct access member to the operator; and (iii) appropriate investor redress mechanisms available. The operator must also make certain risk disclosures and have in place adequate systems and controls to address market integrity, anti-money laundering and other investor protection risks;
requirements for firms providing custody of Investment Tokens (termed “digital wallet service providers”) – for example: (i) any DLT application used in providing custody of the Investment Tokens must be resilient, reliable and compatible with any relevant facility on which the Investment Tokens are traded or cleared; and (ii) the technology used and its associated procedures must have adequate security measures (including cyber security) to enable the safe storage and transmission of data relating to the Investment Tokens; and
a requirement that firms carrying on one or more financial services with respect to Investment Tokens (such as dealing in investments as principal/agent, arranging deals in investments, advising on financial products and managing assets), provide the client with a “key features document” in good time before the service is provided. This must contain, amongst other things: (i) the risks associated with, and the essential characteristics of, the Investment Token; (ii) whether the Investment Token is, or will be, admitted to trading (and, if so, the details of its admission); (iii) how the client may exercise any rights conferred by the Investment Tokens (such as voting); and (iv) any other information relevant to the particular Investment Token that would reasonably assist the client to understand the product and technology better and to make informed decisions in respect of it.

Comment

In taking the approach to Investment Tokens outlined in this alert, the DFSA has aligned with the approach taken by certain key jurisdictions. It is similar to that taken by the U.K. Financial Conduct Authority, for example, which has issued guidance to the effect that tokens with specific characteristics that mean they provide rights and obligations akin to specified investments, like a share or a debt instrument (the U.K. version of Investment Tokens) be treated as specified investments and, therefore, be considered within the existing regulatory framework[3].

The DFSA’s regime has baked-in flexibility, particularly as a consequence of the fairly high level, principles-based approach. This will likely prove helpful, given the evolving nature of the virtual assets world. However, the exclusion of key cryptocurrencies from the scope of this regime may limit the attractiveness of the regime, particularly to cryptocurrency exchanges seeking to offer spot trading. However, this may be offset to some extent by the DFSA regime’s willingness to allow operators of facilities for Investment Tokens to provide direct access to retail clients, subject to those clients meeting certain requirements (such as having sufficient competence and experience). This is in contrast to the approach proposed by the Hong Kong Financial Services and the Treasury Bureau, which has proposed restricting access to cryptocurrency trading to professional investors only.[4]

Next steps

As noted above, the Investment Tokens regime does not cover many key virtual assets. However, we understand that the DFSA is drafting proposals for tokens not covered by the Investment Tokens regulatory framework. These proposals are expected to cover exchange tokens, utility tokens and certain asset-backed tokens (stablecoins). The DFSA intends to issue a second consultation paper later in Q4 of this year.[5]

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[1] https://www.dfsa.ae/news/dfsa-introduces-regulatory-framework-investment-tokens

[2] DFSA Rulebook: General Module, A.2.1.1

[3] FCA Policy Statement (PS 19/22), Guidance on Cryptoassets (July 2019)

[4] See our previous alert on the proposed Hong Kong regime: https://www.gibsondunn.com/licensing-regime-for-virtual-asset-services-providers-in-hong-kong/

[5] https://www.dfsa.ae/news/dfsa-introduces-regulatory-framework-investment-tokens

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. If you wish to discuss any of the matters set out above, please contact any member of Gibson Dunn’s Crypto Taskforce (cryptotaskforce@gibsondunn.com) on the Global Financial Regulatory team, or the following authors:

Hardeep Plahe – Dubai (+971 (0) 4 318 4611, hplahe@gibsondunn.com)
Michelle M. Kirschner – London (+44 (0) 20 7071 4212, mkirschner@gibsondunn.com)
William R. Hallatt – Hong Kong (+852 2214 3836, whallatt@gibsondunn.com)
Chris Hickey – London (+44 (0) 20 7071 4265, chickey@gibsondunn.com)
Martin Coombes – London (+44 (0) 20 7071 4258, mcoombes@gibsondunn.com)
Emily Rumble – Hong Kong (+852 2214 3839, erumble@gibsondunn.com)
Arnold Pun – Hong Kong (+852 2214 3838, apun@gibsondunn.com)
Becky Chung – Hong Kong (+852 2214 3837, bchung@gibsondunn.com)

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

On November 1, 2021, the President’s Working Group on Financial Markets,[1] joined by the Office of the Comptroller of the Currency (OCC) and Federal Deposit Insurance Corporation (FDIC), issued its expected report (Report) on stablecoins, a type of digital asset that has recently grown significantly in market capitalization and importance to the broader digital asset markets.[2]

Noting gaps in the regulation of stablecoins, the Report makes the following principal recommendations:

Congress should promptly enact legislation to provide a “consistent and comprehensive” federal prudential framework for stablecoins –
- Stablecoin issuers should be required to be insured depository institutions
- Custodial wallet providers that hold stablecoins on behalf of customers should be subject to federal oversight and risk-management standards
- Stablecoin issuers and wallet providers should be subject to restrictions on affiliations with commercial entities.
In the absence of Congressional action, the Financial Stability Oversight Council (FSOC) should consider steps to limit stablecoin risk, including designation of certain stablecoin activities as systemically important payment, clearing, and settlement activities.

The Report thus calls for the imposition of bank-like regulation on the world of stablecoins, and it does so with a sense of urgency. Below we summarize the Report’s key conclusions and recommendations, and then preview the path forward if the FSOC is to take up the Report’s call to action.

Stablecoins

A stablecoin is a digital asset that is created in exchange for fiat currency that a stablecoin issuer receives from a third-party; most stablecoins offer a promise or expectation that the stablecoin can be redeemed at par on request. Although certain stablecoins are advertised as being backed by “reserve assets,” there are currently no regulatory standards governing such assets, which can range on the risk spectrum from insured bank deposits and Treasury bills to commercial paper, corporate and municipal bonds, and other digital assets. Indeed, in October, the CFTC took enforcement action against the issuers of US Dollar Tether (USD Tether) for allegedly making untrue or misleading statements about USD Tether’s reserves.[3]

The market capitalization of stablecoins has grown extremely rapidly in the last year; according to the Report, the largest stablecoin issuers had, as of October, a market capitalization exceeding $127 billion.[4] The Report states that stablecoins are predominantly used in the United States to facilitate the trading, lending, and borrowing of other digital assets – they replace fiat currency for participants in the trading markets for Bitcoin and other digital assets and allow users to store and transfer value associated with digital asset trading, lending, and borrowing within distributed ledger environments.[5] The Report further notes that certain stablecoin issuers believe that stablecoins should be used in the payment system, both for domestic goods and services, and for international remittances.[6] Stablecoins, the Report asserts, are also used as a source of collateral against which participants in the digital assets markets can borrow to fund additional activity, “sometimes using extremely high leverage,” as well as to “earn yield,” by using stablecoins as collateral for extending loans and engaging in margined transactions.[7]

Perceived Risks of Stablecoins

The Report views the stablecoin market as currently having substantial risks not subject to regulation.

First, the Report asserts that stablecoins have “unique risks” associated with secondary market activity and market participants beyond the stablecoin issuers themselves, because most market participants rely on digital asset trading platforms to exchange stablecoins with national currencies and other stablecoins.[8] In addition, the Report states that the active trading of stablecoins is part of an essential stabilization mechanism to keep the price of the stablecoin close to or at its pegged value.[9] It further asserts that digital asset trading platforms typically hold stablecoins for customers in non-segregated omnibus custodial wallets and reflect trades on internal records only, and that such platforms and their affiliates may also engage in active trading of stablecoins and as market makers.[10]

Second, the Report argues that stablecoins play a central role in Decentralized Finance (DeFi). It gives two examples – first, stablecoins often are one asset in a pair of digital assets used in “automated market maker” arrangements, and second, they are frequently “locked” in DeFi arrangements to garner yield from interest payments made by persons borrowing stablecoins for leveraged transactions.[11]

As a result, the Report describes a range of risks arising from stablecoins, including risks of fraud, misappropriation, and conflicts of interest and market manipulation; the risk that failure of disruption of a digital asset trading platform could threaten stablecoins; the risk that failure or disruption of a stablecoin could threaten digital asset trading platforms; money laundering and terrorist financing risks; risks of excessive leverage on unregulated trading platforms; risks of non-compliance with applicable regulations; risks of co-mingling trading platform funds with funds of customers; risks flowing from information asymmetries and market abuse; risks from unsupervised trading; risks from distributed-ledger based arrangements, including governance, cybersecurity, and other operational risks; and risks from novel custody and settlement processes.[12]

The Report also notes the risk of stablecoin “runs” that could occur upon loss of confidence in a stablecoin and the reserves backing it, as well as risks to the payment system generally if stablecoins became an important part of the payment system. The Report notes that “unlike traditional payment systems where risk is managed centrally by the payment system operator,” some stablecoin arrangements feature “complex operations where no single organization is responsible or accountable for risk management and resilient operation of the entire arrangement.”[13]

Finally, the Report asserts that the rapid scaling of stablecoins raises three other sets of policy concerns. First is the potential systemic risk of the failure of a significant stablecoin issuer or key participant in a stablecoin arrangement, such as a custodial wallet provider.[14] Second, the Report points to the business combination of a stablecoin issuer or wallet provider with a commercial firm as raising economic concentration concerns traditionally associated with the mixing of banking and commerce.[15] Third, the Report states that if a stablecoin became widely accepted as a means of payment, it could raise antitrust concerns.[16]

Recommendations

The Report’s key takeaway is that the President’s Working Group, the OCC and the FDIC believe that there are currently too many regulatory gaps relating to stablecoins and DeFi. The Report does note that, in addition to existing anti-money laundering and anti-terrorist financing regulations, stablecoin activities may implicate the jurisdiction of the SEC and CFTC, because certain stablecoins may be securities or commodities. Indeed, the CFTC just recently asserted that Bitcoin, Ether, Litecoin and USD Tether are commodities.[17] Nonetheless, the Report states that as stablecoin markets continue to grow, “it is essential to address the significant investor and market risks that could threaten end users and other participants in stablecoin arrangements and secondary market activity.”[18]

The Report therefore calls for legislation to close what it sees as the critical gaps. First, it argues that stablecoin issuance, and the related activities of redemption and maintenance of reserve assets, should be limited to entities that are insured depository institutions: state and federally chartered banks and savings associations that are FDIC insured and have access to Federal Reserve services, including emergency liquidity.[19] Legislation should also ensure that supervisors have authority to implement standards to promote interoperability among stablecoins.[20] Given the global nature of stablecoins, the Report contends that legislation should apply to stablecoin issuers, custodial wallet providers, and other key entities “that are domiciled in the United States, offer products that are accessible to U.S. persons, or that otherwise have a significant U.S. nexus.”[21]

Second, given the Report’s perceived risks of custodial wallet providers, the Report argues that Congress should require those providers to be subject to “appropriate federal oversight,” including restricting them from lending customer stablecoins and requiring them to comply with appropriate risk-management, liquidity, and capital requirements.[22]

Third, because other entities may perform activities that are critical to the stablecoin arrangement, the Report argues that legislation should provide the supervisor of a stablecoin issuer with the authority to require any entity that performs activities “critical to the functioning of the stablecoin arrangement” to meet appropriate risk-management standards, and give the appropriate regulatory agencies examination and enforcement authority with respect to such activities.[23]

Finally, the Report advocates that both stablecoin issuers and wallet providers should, like banks, be limited in their ability to affiliate with commercial firms.[24]

Interim Measures

The Report characterizes the need for legislation as “urgent.” While legislation is being considered, the Report recommends that the Financial Stability Oversight Council (FSOC) consider taking actions within its jurisdiction, such as designating certain activities conducted within stablecoin arrangements as systemically significant payment, clearing, and settlement activities.[25] The Report states that such designation would permit the appropriate federal regulatory agency to establish risk-management requirements for financial institutions[26] that engage in the designated activities.

Such designations would occur pursuant to Title VIII of the Dodd-Frank Act, and it would be the first time that the FSOC would make them.[27] The procedure that the FSOC must follow is set forth in Title VIII, and, absent an emergency, it appears that it would not be a quick one. First, the FSOC must consult with the relevant federal supervisory agencies and the Federal Reserve.[28] Next, it must provide notice to the financial institutions whose activities are to be designated, and offer those institutions the opportunity for a hearing.[29] The institutions may then choose to appear, personally or through counsel, to submit written materials, or, at the sole discretion of FSOC, to present oral testimony or argument.[30] The FSOC must approve the activity designation by a vote of at least two-thirds of its members, including an affirmative vote by the Chair.[31] The FSOC must consider the designation in light of the following factors: (i) the aggregate monetary value of transactions carried out through the activity, (ii) the aggregate exposure of the institutions engaged in the activity to their counterparties, (iii) the relationship, interdependencies, or other interactions of the activity with other payment, clearing, or settlement activities, (iv) the effect that the failure of or a disruption to the activity would have on critical markets, financial institutions, or the broader financial system, and (v) any other factors that the FSOC deems appropriate.[32]

Conclusion

With the Report, Treasury and the relevant federal agencies – the Federal Reserve, the SEC, CFTC, OCC, and FDIC – have made it clear that they believe that the risks of stablecoin activities are not fully mitigated by existing regulation. Their recommendations for legislation look principally to bringing stablecoins within the banking system and to bank regulation as a means of addressing those risks. It is an open question, however, whether Congress will act, much less with the urgency that the Report desires. Action by the FSOC, moreover, will almost certainly take some time, given the statutory designation procedures. In the near term, therefore, it is likely to fall to the existing agencies with some jurisdiction over stablecoins – the CFTC and SEC – to address the gaps with the tools at their disposal.[33]

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[1] The Working Group comprises representatives of the Treasury Department (Treasury), Board of Governors of the Federal Reserve System (Federal Reserve), the Securities and Exchange Commission (SEC), and Commodity Futures Trading Commission (CFTC).

[2] See https://home.treasury.gov/system/files/136/StableCoinReport_Nov1_508.pdf.

[3] See https://www.gibsondunn.com/digital-asset-developments-us-commodity-futures-trading-commission-asserts-that-tether-is-a-commodity/.

[4] Report, at 7. In addition to USD Tether, the most circulated stablecoins are USD Coin, Binance USD, Dai Stablecoin, and TrueUSD. All are pegged to the U.S. dollar.

[5] Id. at 8.

[6] Id.

[7] Id.

[8] Id.

[9] Id.

[10] Id.

[11] Id. at 9.

[12] Id. at 10-11.

[13] Id. at 12-13.

[14] Id. at 14.

[15] Id.

[16] Id.

[17] See https://www.gibsondunn.com/digital-asset-developments-us-commodity-futures-trading-commission-asserts-that-tether-is-a-commodity/.

[18] Report, at 11.

[19] Id. at 16. Unless the insured depository institution in question is an industrial bank, requiring the stablecoin issuer to be an insured depository institution would also be a requirement for the issuer’s parent company, if any, to be a bank or thrift holding company supervised and regulated by the Federal Reserve.

[20] Id.

[21] Id. n. 29.

[22] Id. at 17.

[23] Id.

[24] Id.

[25] Id. at 18.

[26] Title VIII defines “financial institution” broadly to reach “any company engaged in activities that are financial in nature or incidental to a financial activity, as described in section 4 of the Bank Holding Company Act,” in addition to banks, credit unions, broker-dealers, insurance companies, investment advisers, investment companies, futures commission merchants, commodity pool operators and commodity trading advisers.

[27] The FSOC has previously undertaken designations of systemically significant nonbank financial companies under Title I of the Dodd-Frank Act and systemically significant financial market utilities under Title VIII of the Dodd-Frank Act.

[28] 12 U.S.C. § 5463(c)(1).

[29] Id. § 5463(c)(2).

[30] Id. § 5463(b)(1).

[31] Id. § 5463(c)(3).

[32] Id. § 5463(a)(2).

[33] In a press release issued just after the Report, the Director of the Consumer Financial Protection Bureau, Rohit Chopra, stated that “stablecoins may . . . be used for and in connection with consumer deposits, stored value instruments, retail and other consumer payments mechanisms, and in consumer credit arrangements. These use cases and others trigger obligations under federal consumer financial protection laws, including the prohibition on unfair, deceptive, or abusive acts or practices.” See https://www.consumerfinance.gov/about-us/newsroom/statement-cfpb-director-chopra-stablecoin-report/.

The following Gibson Dunn lawyers assisted in preparing this client update: Arthur Long and Jeffrey Steiner.

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, the author, or any of the following members of the firm’s Financial Institutions practice group:

Matthew L. Biben – New York (+1 212-351-6300, mbiben@gibsondunn.com)
Michael D. Bopp – Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com)
Stephanie Brooker – Washington, D.C. (+1 202-887-3502, sbrooker@gibsondunn.com)
M. Kendall Day – Washington, D.C. (+1 202-955-8220, kday@gibsondunn.com)
Mylan L. Denerstein – New York (+1 212-351- 3850, mdenerstein@gibsondunn.com)
William R. Hallatt – Hong Kong (+852 2214 3836, whallatt@gibsondunn.com)
Michelle M. Kirschner – London (+44 (0) 20 7071 4212, mkirschner@gibsondunn.com)
Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com)
Matthew Nunan – London (+44 (0) 20 7071 4201, mnunan@gibsondunn.com)
Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com)

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

On Friday October 15, 2021, the Commodity Futures Trading Commission (CFTC) issued an enforcement order (Tether Order) against the issuers of the U.S. dollar Tether token (USDT), a leading stablecoin, and fined those issuers $41 million for making untrue or misleading statements about maintaining sufficient fiat currency reserves to back each USDT “one-to-one.”[1] In so doing, the CFTC asserted that USDT is a “commodity” under the Commodity Exchange Act (CEA).

The Tether Order is significant for few reasons. First, it marks the first U.S. enforcement action against a major stablecoin. Second, the CFTC has now asserted that it has some enforcement authority over stablecoins, just at the time that the Biden Administration is gearing up its regulatory approach to digital currencies in general and stablecoins in particular. Securities and Exchange Commission (SEC) Chair Gary Gensler stated earlier this year that he believed that certain stablecoins, such as those backed by securities, are securities,[2] and the President’s Working Group on Financial Markets will soon be issuing a report on stablecoins.[3] Third, the CFTC’s assertion that USDT is a commodity signals that stablecoins that are backed one-to-one with fiat currency are not securities and therefore are not directly subject to the SEC’s jurisdiction.

CFTC Legal Authority

Although the CFTC is principally a regulator of the markets for commodity futures and derivatives such as swaps, it does have certain enforcement authority over commodities in the cash markets (i.e., spot commodities). Section 6(c)(1) of the Commodity Exchange Act, provides that it is “unlawful for any person, directly or indirectly, to use or employ, or attempt to use or employ, in connection with any swap, or a contract of sale of any commodity in interstate commerce, . . . any manipulative or deceptive device or contrivance, in contravention of such rules and regulations as the Commission shall promulgate.”[4] The CFTC has promulgated regulations pursuant to Section 6(c)(1), which render unlawful intentional or reckless statements or omissions “in connection with . . . any contract of sale of any commodity in interstate commerce.”[5] When those regulations were promulgated, the CFTC stated that “[it] expect[ed] to exercise its authority under 6(c)(1) to cover transactions related to the futures or swaps markets, or prices of commodities in interstate commerce, or where the fraud or manipulation has the potential to affect cash commodity, futures, or swaps markets or participants in these markets.”[6]

Tether Order

Prior to the Tether Order, the CFTC had asserted that some digital assets are commodities.[7] The Tether Order definitively states that USDT is a commodity (and, in dicta, asserts that bitcoin, ether, and litecoin are commodities as well). It then alleges that the issuers of USDT made material misstatements under Section 6(c)(1) of the CEA and its implementing regulations regarding whether USDT was backed on a one-to-one basis with fiat currency reserves and whether this reserving would undergo regular professional audits, and the issuers made material omissions regarding the timing of one of the reserve reviews that USDT issuers did take.[8] Without admitting or denying the CFTC’s findings and conclusions, the USDT issuers consented to the entry of a cease-and-desist order and civil money penalty of $41 million.[9]

Conclusion

The recent past has seen the explosive growth of the digital asset markets, with regulators globally seeking to catch up. In the United States, the challenge has been, in the absence of new legislation, to make digital asset transactions fit within existing regulatory schemes. Much initial regulation has been at the state level; most federal financial regulators have initially been attempting to regulate through enforcement. Now, however, there is the prospect of overlapping federal regulation, particularly with respect to stablecoins. The Tether Order comes at a time when media outlets have reported that the U.S. Department of Treasury will be working with U.S. financial regulators to issue a broad report on stablecoins, including how stablecoins should be regulated. And although the CFTC has taken its position on USDT, it is currently still unclear how other U.S. regulators will view stablecoins and other digital assets.

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[1] In the Matter of Tether Holdings Limited, Tether Operations Limited, Tether Limited, and Tether International Limited, CFTC Docket No. 22-04 (Oct. 15, 2021), available at https://www.cftc.gov/media/6646/enftetherholdingsorder101521/download.

[2] Gary Gensler, SEC Chair, “Remarks Before the Aspen Security Forum” (August 3, 2021).

[3] See, e.g., Michelle Price, “Explainer: How the U.S. Regulators Are Cracking Down on Cryptocurrencies,” Reuters, September 24, 2021.

[4] 7 U.S.C. § 9(1).

[5] 17 C.F.R. § 180.1(a)(2).

[6] CFTC, Final Rules: Prohibition on the Employment, or Attempted Employment, of Manipulative and Deceptive Devices and Prohibition on Price Manipulation, 76 Fed. Reg. 41,398, 41,401 (July 14, 2011).

[7] See, e.g., In re Coinflip, Inc., CFTC No. 15-29, 2015 WL 5535736, at * 2 (Sept. 17, 2015) (stating that bitcoin is properly defined as a commodity within the meaning of the CEA).

[8] Tether Order at 8-9.

[9] Also on October 15, the CFTC entered into a consent order with Bitfinex, a leading digital currency exchange that has many management and operational interlocks with the USD Tether issuers, for allegedly permitting U.S. customers that were not eligible contract participants to engage in leveraged, margined or financed commodity transactions that were not carried out on a designated contract market (i.e., a CFTC registered futures exchange) in violation of the CEA’s requirements, and acting as a futures commission merchant (FCM) without being registered with the CFTC as such. The CFTC further asserted that Bitfinex had violated a 2016 CFTC order that had commanded it to cease-and-desist from such activity. Without admitting or denying the CFTC’s findings and conclusions, Bitfinex consented to the entry of the new cease-and-desist order and a $1 million fine. See In the Matter of iFinex Inc., BFXNA Inc., and BFXWW Inc., CFTC Docket No. 22-05 (Oct. 15, 2021), available at https://www.cftc.gov/media/6651/enfbfxnaincorder101521/download.

The following Gibson Dunn lawyers assisted in preparing this client update: Arthur Long and Jeffrey Steiner.

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

On September 23, 2021, President Joseph Biden announced his intention to nominate Professor Saule Omarova of Cornell Law School to be the next Comptroller of the Currency. The Comptroller heads the Office of the Comptroller of the Currency (OCC), the Treasury bureau that supervises national banks and federal thrifts; the Comptroller is also an ex officio member of the Board of Directors of the Federal Deposit Insurance Corporation (FDIC).

If confirmed by the Senate, Professor Omarova will have significant influence over regulatory policy, not only for banking institutions, but also for fintech companies that seek to enter the banking system via either a national bank or FDIC-insured industrial bank charter or that have bank partners.

Professor Omarova worked in the Bush Treasury Department and has published numerous articles on financial regulation. This Alert touches on the key themes of her academic writings and addresses how these themes could translate into regulatory priorities at the OCC and FDIC, and in view of the fact that President Biden will likely soon nominate a new Vice Chair for Supervision at the Board of Governors of the Federal Reserve System (Federal Reserve).

A. Key Themes

Professor Omarova has written on numerous topics in her academic career. Early on, she analyzed 1990s OCC interpretations that expanded national bank derivatives activities to include derivatives on commodities and equities; the Federal Reserve’s granting of Section 23A exemptions immediately before and during the 2008 Financial Crisis; and the historical exemptions from the definition of a “bank” under the Bank Holding Company Act.[1] More recently, she has written on bank governance, innovation in the financial industry, “culture” at financial institutions, restructuring the Federal Reserve to take customer demand deposits, and the “Too Big to Fail” problem, among other topics.[2]

Several key themes emerge from these writings:

Concerns that post-Financial Crisis reforms have only magnified the size and interconnectedness of the largest banking organizations
Concerns that banking and related financial activities frequently serve only private interests
Concerns that activities outside of narrow banking – derivatives, commodities, trading, and even certain capital markets activities – are inherently risky
Concerns that a focus on “innovation” may result in a weakening of supervisory standards

Perhaps most interesting, however, is Professor Omarova’s recurring theme that traditional bank supervision is too narrowly focused on what she calls “micro” issues and solutions, and that a new regulatory paradigm centered on overall “macro” economic and public interest goals, and including substantially increased government intervention in the financial sector, may be needed.

1. Concern with Size and Interconnectedness

Professor Omarova, like other observers, has noted one of the ironies of post-Financial Crisis regulation – that although the size and interconnectedness of the global banking sector contributed significantly to the Crisis, the financial system was saved only by increasing the size of the nation’s largest banks:

The post-crisis increase in the level of concentration of the U.S. financial industry is difficult to deny. For example, as of the year-end 2017, top five U.S. bank holding companies (BHCs) held forty-eight percent of the country’s BHC assets. By early 2018, there were four U.S. BHCs with more than $1.9 trillion in assets on their individual balance sheets. Despite the post-crisis passage of the Dodd-Frank Act, the most wide-ranging regulatory reform in the U.S. financial sector since the 1930s, [too big to fail] remains a “live” issue on the public policy agenda.[3]

This in turn, she believes, imposes considerable challenges for supervisors: “today’s financial system is growing increasingly complex and difficult to manage. This overarching trend manifests itself not only in the dazzling organizational complexity of large financial conglomerates, but also in the exponential growth of complex financial instruments – derivatives, asset-backed securities, and other structured products – and correspondingly complex markets in which they trade.”[4] The result is that it is “extremely difficult to measure and analyze not only the overall pattern of risk distribution in the financial system but also the true level of individual financial firms’ risk exposure.”[5]

2. Private Versus Public Interest

It is fair to say that Professor Omarova is not a strong believer in the “Invisible Hand.” Her articles frequently posit a dichotomy between the driving forces of finance and the “public interest.” Her article on bank culture, for example, makes this assertion:

[New York Federal Reserve Bank President] Gerald Corrigan argued that, in exchange for the publicly-conferred benefits uniquely available to them, banks have an obligation to align their implicit codes – and their actual conduct – with the public good. In practice, however, there has been little evidence of such an alignment . . . . One of the most troubling revelations [about bank conduct before the Financial Crisis] was that, in the vast majority of these cases, banks’ and their employees’ socially harmful and ethically questionable business conduct was perfectly permissible under the existing legal rules. In each of those instances, bankers voluntarily, and often knowingly, chose to pursue a particular privately lucrative but socially suboptimal business strategy. And, as long as mortgage markets kept going up and speculative trading in mortgage assets remained profitable, bankers showed no interest in fulfilling their public duties or prioritizing moral values over pecuniary self-interest.[6]

In an article on bank governance, she returns to this theme, stating that “[a]ll too often, however, the incentives of bank managers and shareholders to pursue short-term private gains are perfectly aligned but work directly against the public interest in preserving long-term financial stability. The recent financial crisis . . . made abundantly clear that the modern system of corporate governance . . . is not a sufficiently reliable or consistent mechanism for managing this insidious and apparently pervasive conflict in a publicly beneficial way.”[7]

Although it is clear how Professor Omarova views what then-Chief Judge Cardozo called “the forms of conduct permissible in a workaday world for those acting at arm’s length,”[8] it is less clear how she defines the “public interest.” Her writings do, however, suggest that it includes a focus on maintaining financial stability and appropriately allocating capital and credit to productive use, which she argues is not likely to occur absent government intervention:

[T]o date, there has been no meaningful debate on improving the system-wide allocation of financial resources to productive enterprise. In most, if not all, post-crisis discussions on financial regulation, the underlying presumption remains that private market actors are inherently better at assessing financial risks and spotting potentially beneficial investment opportunities ‘on the ground.’ Accordingly, the existing dysfunctions in the process of system-wide credit allocation are framed predominantly in terms of specific private incentive misalignments or more general political-economy frictions.[9]

3. Preference for Narrow Banking

From her earliest writings, Professor Omarova has expressed a distrust of activities that are not at the core of traditional commercial banking. In an early article, she took issue with the OCC’s increasingly flexible approach to interpreting the phrase “business of banking” in the National Bank Act to include derivative activities related to commodities and equities, including hedging such activities through physically settled transactions, and related activities such as national bank participation in power marketing and clearing organizations.[10] She similarly criticized Federal Reserve interpretations of the Gramm-Leach-Bliley Act under which commodity activities were deemed “complementary” to financial activities, and investments in commodity-related assets could be permissible merchant banking investments.[11] (It is worthwhile remembering that under Governor Daniel Tarullo, the Federal Reserve commenced an advanced notice of proposed rulemaking to consider established commodity activities by financial holding companies.[12]) And Professor Omarova strongly supported the statutory Volcker Rule but feared that the law’s mandated administrative rulemakings had great potential to weaken it.[13]

These concerns about risks from non-traditional activities extend to capital markets activities generally, including those that were broadly permissible for bank holding companies even before the Gramm-Leach-Bliley Act was enacted. (By 1997, the Federal Reserve had interpreted the Glass-Steagall Act in a manner that posed few limits on corporate debt and equity underwriting and dealing, in addition to underwriting and dealing in bank-permissible assets.[14]) Professor Omarova states that “[i]n today’s world, secondary markets in financial assets are far bigger, more complex, and more systemically important than primary markets. . . . It is not surprising, therefore, that today’s secondary markets in financial instruments are the principal sites of both relentless transactional ‘innovation’ and chronic over-generation of systemic risk.”[15] In criticizing the Federal Reserve’s Section 23A exemptions granted during the Financial Crisis, she argued that “it is hard to deny that these extraordinary liquidity backup programs also functioned to prop up the banks’ broker-dealer affiliates, which . . . were in the business of creating, trading, and dealing in securities that needed . . . financing and, as a result, had direct exposure to . . . highly unstable markets.”[16]

4. Innovation as a Source of Risk

In contrast to former Acting Comptroller Brian Brooks, who encouraged financial innovation, most notably with respect to national charters for virtual currency companies, Professor Omarova has had a skeptical eye on the question. One of her early articles, as noted above, criticized the OCC for its interpretive approach with respect to equity and commodity derivatives:

[T]he OCC’s highly expansive interpretation of the “business of banking” . . . served to undermine the integrity and efficacy of the U.S. system of bank regulation. Through the seemingly routine and often nontransparent administrative actions, the OCC effectively enabled large U.S. commercial banks to transform themselves from the traditionally conservative deposit-taking and lending institutions, whose safety and soundness were guarded through statutory and regulatory restrictions on potentially risky activities, into a new breed of financial “super-intermediaries,” or wholesale dealers in pure financial risk.[17]

This view carries over in later discussions of pre-Financial Crisis loan securitizations and credit default swaps, as well as fintech generally. Of the latter, Professor Omarova has written:

By making transacting in financial markets infinitely faster, cheaper, and easier to accomplish, fintech critically augments the ability of private actors to synthesize tradable financial claims – or private liabilities – and thus generate new financial risks on an unprecedented scale. Moreover, as the discussion of Bitcoin and ICOs shows, new crypto-technology enables private firms to synthesize tradable financial assets effectively out of thin air. . . . The sheer scale and complexity of the financial market effectively “liberated” from exogenously imposed constraints on its growth will make it inherently more volatile and unstable . . . . The same factors, however, will also make it increasingly difficult, if not impossible, for the public to control, or even track, new technology-driven proliferation of risk in the financial system.[18]

5. The Futility of Bank Supervision

Perhaps most interestingly for someone who would be the lead supervisor of most of the nation’s largest banks, Professor Omarova’s writings show a decidedly pessimistic view of the effectiveness of financial regulation. She frequently points out the failures of what she terms “micro” entity-specific solutions to such risks, in order to argue in favor of a revised “macro,” i.e., far more fundamental and structural, approach. One example comes from her article on Too Big To Fail: “At the heart of the TBTF problem, there is a fundamental paradox: TBTF is an entity-centric, micro-level metaphor for a cluster of interrelated systemic, macro-level problems. This inherent conceptual tension between the micro and the macro, the entity and the system, frames much of the public policy debate on TBTF.”[19]

Professor Omarova’s “macro” approach includes suggestions of potential governmental interventions in the financial system on a scale unprecedented even in times of crisis – government “golden shares” in large financial companies that would allow the government to override management decisions to forestall a crisis,[20] Federal Reserve counter-cyclical intervention in a broader range of financial markets,[21] “public interest” guardians who would supplement regulatory bodies to correct the self-interest of the financial sector,[22] and a significant National Investment Authority to counteract the biases of the private investment community.[23] As Professor Omarova acknowledges, such measures would require new legislation, for which there does not currently appear to substantial appetite.

B. Consequences For Regulatory Priorities

What then do these themes likely foretell should Professor Omarova receive Senate confirmation? It is of course always a challenge to predict the future, and academic writing is frequently at its best when it seeks to challenge traditional paradigms and manners of thought. This said, it does seem that the following outcomes are certainly within the realm of possibility.

1. Size and Interconnectedness

The OCC currently supervises eight of the country’s ten largest banks: JPMorgan Chase, Bank of America, Wells Fargo, Citibank, US Bank, PNC Bank, TD Bank, and Capital One, ranging from just under $400 billion in assets to over $3 trillion in assets. Some, but not all, of them also engage broadly in investment banking activities. The OCC also regulates many banks in the next asset tier below.

The OCC does not have any general authority to break up well-managed banks or to order them to cease activities, but it is not unusual for the OCC to adjust its supervisory approach based on the risk profile of an institution. What Professor Omarova might add to this traditional approach given her views of increasing systemic risk and the importance of the “macro” is a more holistic approach, in which not only will a particular institution’s own risk profile determine its supervision, but also the perceived risks created by those institutions to which it is most connected. In addition, large banks that fail to meet supervisory expectations can face activities limitations; an early article by Professor Omarova analyzed the idea of requiring regulatory approval of complex financial products.[24]

Moreover, although mergers of bank holding companies must be approved only by the Federal Reserve, in many cases once the holding company merger has been approved, the parties seek to merge the subsidiary banks for efficiency reasons. If the resulting bank will be a national bank, the OCC must approve the transaction under the Bank Merger Act. The statutory factors that the OCC must consider are similar to those the Federal Reserve considers, but the OCC makes an independent decision. Many of the required factors relate to size – competitive effect, ability of management (including on integrating institutions), and financial stability.[25]

2. Private Interest Versus Public Interest

In terms of constraining what Professor Omarova views as the self-interest of the financial sector, it is noteworthy that the responsible agencies, including the OCC, have never completely finalized the executive compensation rulemaking required by Dodd-Frank, something to which SEC Chair Gary Gensler has recently called attention.[26] One of the more controversial aspects of the original rulemaking was the extent of permissible clawbacks of compensation, if actions by individual bankers ended up imposing losses on the financial institution involved. On this question, Professor Omarova’s characterization of the “morals of the marketplace” could be significant.

Another means by which the bank regulators have sought to address privatizing gains and socializing losses since the Crisis is bank governance. The OCC’s principal contribution in this regard is its Guidelines Establishing Heightened Standards for large national banks and federal thrifts, which impose a prescriptive approach to certain aspects of bank corporate governance.[27] These Guidelines were adopted as safety and soundness standards pursuant to Section 39 of the Federal Deposit Insurance Act, which gives the OCC the authority to issue orders for noncompliance, orders that may be enforced by the issuance of civil money penalties or in federal district court actions. The OCC could further strengthen these standards or take a more aggressive approach to enforcing them.

3. Narrow Banking

Historically, as Professor Omarova herself has noted, the OCC has been one of the most flexible agencies in its interpretations of its governing statute, the National Bank Act. Although certain of the activities that she has criticized for increasing systemic risk are conducted by bank affiliates, not all of them are: national banks conduct significant derivative activities, certain capital markets activities are bank permissible, and numerous bank activities implicate the broad definition of proprietary trading contained in the Volcker Rule. Even in the absence of revisiting, for example, the National Bank Act interpretations relating to permissible derivatives activities, the OCC has the authority to examine all national bank activities. Those banking institutions with substantial businesses in areas that Professor Omarova has characterized as non-core and risk-creating should therefore expect a much stricter supervisory approach. The Volcker Rule regulations, which as revised still invite significant supervisory discretion in practice due to the difficulty of distinguishing between prohibited trading and permissible activities like risk-mitigating hedging, could well see ramped up examination interest, and expectations of compliance programs could increase.

4. Innovation and Fintechs

There are currently several pressing fintech-related issues at the OCC. First is the question of whether the OCC will grant a national bank charter to a company that proposes to make loans but not take FDIC-insured deposits, and that is not a statutorily authorized national trust bank. The OCC has claimed the authority under the National Bank Act to issue such a charter, but it has not acted on one such application, and it has been sued in federal court by state banking supervisors who believe that granting such a charter goes beyond the business of banking in the National Bank Act. Professor Omarova’s statements on the potential perils of innovation for supervisors and her general “public interest” concerns may well be relevant on this question.

Second, shortly before and just after President Biden was inaugurated, the OCC granted three trust company charters to digital currency companies, and issued a broad interpretation of permissible digital currency activities under the National Bank Act. The OCC is currently re-examining the bases for such charters, with Acting Comptroller Hsu expressing safety and soundness concerns over certain virtual currency activities. For Professor Omarova, virtual currencies and other digital assets are one of the areas where innovation is most likely to cause systemic risk.[28]

Third, Professor Omarova will be a voting member of the FDIC Board, which determines whether a state industrial bank may receive deposit insurance, and which also must approve any change of control transaction involving an FDIC-insured industrial bank. Under Chair Jelena McWilliams – but with a Republican-appointed Comptroller and Republican-appointed Director of the Consumer Financial Protection Bureau – the FDIC Board approved two such applications, one for Square and one for Nelnet. In one of her earliest articles, Professor Omarova analyzed the historical exemption for industrial banks in the Bank Holding Company Act,[29] and since that writing, Congress has refused to repeal the exemption, and the FDIC has finalized a framework for supervising the parents of industrial banks. It is certainly possible that given her preference was “narrow” banking, Professor Omarova would wish to see a linkage to traditional banking activities, with ancillary activities being preferable when conducted in an agency capacity, when considering such applications.

Finally, many fintechs operate via bank partnerships. Under the Trump Administration, the OCC issued fintech-friendly interpretations regarding the “true lender” and “valid when made” doctrines, which engendered opposition from consumer groups and certain state regulators and attorneys general. Congress used the Congressional Review Act this summer to void the “true lender” rule, but the “valid when made” interpretation remains. Professor Omarova’s criticism of the elasticity of the OCC’s interpretations of the National Bank Act on derivatives matters during the 1990s could extend beyond the derivatives area to bank-fintech partnership issues. Demonstrating a lack of increased risk to banks and the system from such partnerships, therefore, could become significant.

5. The Quarles/Brainard Divide – Likely Positioning

It is also important to note that Professor Omarova’s appointment is not taking place in a vacuum. In several weeks, Vice Chair Randal Quarles’s term as the Federal Reserve Governor in charge of bank supervision will come to an end, although a mere Governor Quarles could remain at the Federal Reserve for another decade. During the last four years, Vice Chair Quarles has shepherded through a number of “reforms to the reform” wrought by the Dodd-Frank Act. Many of the more important actions drew dissents from Governor Lael Brainard, who is one of the contenders to be Governor Quarles’ successor. Of these actions, quite a few implicated rules promulgated by the OCC as well as the Federal Reserve:

Loosening the regulatory restrictions of the Volcker Rule
Tailoring capital and liquidity requirements for an institution’s asset size and other factors, with institutions between $100 billion and $250 billion in assets particularly benefiting
Reducing margin requirements for inter-affiliate uncleared swap transactions
Proposing to reduce the enhanced supplementary leverage ratio for the largest banks and their holding companies

From her articles, Professor Omarova would appear to be decidedly in Governor Brainard’s camp on these four issues.

Conclusion: The Limits of Bank Supervision and Regulation

In her writings, Professor Omarova is a strong proponent for government intervention in the financial system, and a skeptic of a light-touch supervisory approach. In this way, she is reminiscent of the first de facto Federal Reserve Governor for bank supervision, another banking law professor turned regulator, Daniel Tarullo. Governor Tarullo, of course, oversaw the implementation of a highly prescriptive top-down approach to bank supervision at the Federal Reserve, which even he noted in his “farewell address” may have gone too far in some areas, particularly for non-systemic banks.[30] Professor Omarova also has quite a bit in common with former FDIC Chair Sheila Bair, who herself was a professor of regulatory policy, was critical of bank derivative activities, and pushed the Collins Amendment to the Dodd-Frank Act because of her suspicions regarding internal bank financial models.

But it is also fair to say that neither Governor Tarullo nor Chair Bair appeared to have quite as skeptical views on the limitations of bank supervision and regulation as Professor Omarova. What will a proponent of a new paradigm approach to the American banking industry do in the absence of any legislative appetite for departing from the reigning paradigm since the New Deal?

This is perhaps the most difficult question of all to answer. A logical response, however, is that in those areas that are perceived to pose the greatest risk, such a proponent would double down on the supervisory tools that are currently available in order to counter perceived risks at inception. Large federal banking institutions that depart from core deposit and lending activities should therefore expect searching supervisory reviews of their non-traditional activities.

_________________________

[1] Saule T. Omarova, “The Quiet Metamorphosis: How Derivatives Changed the ‘Business of Banking,’” 63 U. Miami L. Rev. 1041 (2009); Saule Omarova, “From Gramm-Leach-Bliley to Dodd-Frank: The Unfulfilled Promise of Section 23A of the Federal Reserve Act,” 89 N.C. L. Rev. 1683 (2011); Saule T. Omarova and Margaret E. Tahyar, “That Which We Call a Bank: Revisiting the History of Bank Holding Company Regulation in the United States,” 31 Rev. Banking & Fin. L. 113 (2012).

[2] Saule T. Omarova, “Bank Governance and Systemic Stability: The ‘Golden Share’ Approach,” 68 Ala. L. Rev. 1029 (2017); Saule T. Omarova, “New Tech v. New Deal: Fintech as a Systemic Phenomenon,” 36 Yale J. on Reg. 735 (2019); Saule T. Omarova, “Ethical Finance as a Systemic Challenge: Risk, Culture, and Structure,” 27 Cornell J.L. & Pub. Pol’y 797 (2018); Saule T. Omarova, “The ‘Too Big to Fail’ Problem,” 103 Minn. L. Rev. 2495 (2019).

[3] “The ‘Too Big to Fail’ Problem,” supra note 2.

[4] Id.

[5] Id.

[6] “Ethical Finance as a Systemic Challenge: Risk, Culture, and Structure,” supra note 2.

[7] “Bank Governance and Systemic Stability: The ‘Golden Share’ Approach,” supra note 2.

[8] Meinhard v. Salmon, 164 N.E. 528 (N.Y. 1928).

[9] Saule T. Omarova, “What Kind of Finance Should There Be?”, 83 Law & Contemp. Probs. 195 (2020).

[10] “The Quiet Metamorphosis: How Derivatives Changed the ‘Business of Banking,’” supra note 1.

[11] Saule T. Omarova, “The Merchants of Wall Street: Banking, Commerce, and Commodities,” 98 Minn. L. Rev. 265 (2013).

[12] See https://www.federalreserve.gov/newsevents/pressreleases/bcreg20140114a.htm.

[13] Saule T. Omarova, “The Dodd-Frank Act: A New Deal for A New Age?”, 15 N.C. Banking Inst. 83 (2011)

[14] See https://www.federalreserve.gov/boarddocs/press/boardacts/1996/19961220/ (increasing limit on bank ineligible revenues for Section 20 companies to 25 percent of total revenues).

[15] “What Kind of Finance Should There Be?”, supra note 9.

[16] “From Gramm-Leach-Bliley to Dodd-Frank: The Unfulfilled Promise of Section 23A of the Federal Reserve Act,” supra note 1.

[17] “The Quiet Metamorphosis: How Derivatives Changed the ‘Business of Banking,’” supra note 1.

[18] “New Tech v. New Deal: Fintech as a Systemic Phenomenon,” supra note 2.

[19] “The ‘Too Big to Fail’ Problem,” supra note 2.

[20] “Bank Governance and Systemic Stability: The ‘Golden Share’ Approach,” supra note 2.

[21] “The ‘Too Big to Fail’ Problem,” supra note 2.

[22] Saule T. Omarova, “Bankers, Bureaucrats, and Guardians: Toward Tripartism in Financial Services Regulation,” 37 J. Corp. L. 621 (2012).

[23] Robert C. Hockett & Saule T. Omarova, “Private Wealth and Public Goods: A Case for a National Investment Authority,” 43 J. Corp. L. 437 (2018).

[24] Saule T. Omarova, “License to Deal: Mandatory Approval of Complex Financial Products,” 90 Wash. U. L. Rev. 63 (2012).

[25] 12 U.S.C. § 1828(c).

[26] Akayla Gardner & Ben Bain, “Wall Street Pay Clawback Rule to Get New Push at SEC,” Bloomberg News (September 22, 2021).

[27] 12 C.F.R. Part 30 (Appendix D).

[28] “New Tech v. New Deal: Fintech as a Systemic Phenomenon,” supra note 2.

[29] “That Which We Call a Bank: Revisiting the History of Bank Holding Company Regulation in the United States,” supra note 1.

[30] See https://www.federalreserve.gov/newsevents/speech/tarullo20170404a.htm.

The following Gibson Dunn lawyers assisted in preparing this client update: Arthur Long.

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

The torrid pace of new securities class action filings over the last several years slowed a bit in the first half of 2021, a period in which there have been many notable developments in securities law. This mid-year update briefs you on major developments in federal and state securities law through June 2021:

In Goldman Sachs, the Supreme Court found that lower courts should hear evidence regarding the impact of alleged misstatements on the price of securities to rebut any presumption of classwide reliance at the class-certification stage, and that defendants bear the burden of persuasion on this issue.
Just before its summer recess, the Supreme Court granted certiorari in Pivotal Software, teeing up a decision on whether the PSLRA’s discovery-stay provision applies to state court actions, which may impact forum selection in private securities actions.
We explore various developments in Delaware courts, including the relative decline of appraisal litigation, and the Court of Chancery’s (1) decision to enjoin a poison pill, (2) rejection of a claim that the COVID-19 pandemic constituted a material adverse effect, (3) approach in a potential bellwether SPAC case, and (4) analysis of post-close employment opportunities with respect to Revlon fiduciary duties.
We continue to survey securities-related lawsuits arising in connection with the coronavirus pandemic, including securities class actions, stockholder derivative actions, and SEC enforcement actions.
We examine developments under Lorenzo regarding disseminator liability and under Omnicare regarding liability for opinion statements.
Finally, we explain important developments in the federal courts, including (1) the widening circuit split regarding the jurisdictional reach of the Exchange Act based on recent decisions in the First and Second Circuits, (2) the Eighth Circuit’s holding that class action allegations, including those under Section 10(b), can be struck from pleadings, (3) Congress’s codification of the SEC’s disgorgement authority in the National Defense Authorization Act, (4) a federal district court’s holding that a forum selection clause superseded anti-waiver provisions in the Exchange Act, and (5) the Ninth Circuit’s broad interpretation of the PSLRA’s safe harbor for forward-looking statements.

I. Filing and Settlement Trends

According to Cornerstone Research, both the number of new filings and the average approved settlement amount in securities class actions decreased relative to the same period last year and historically. However, the number of approved settlements is the highest it has been since the second half of 2017, indicating that 2021 may be on track to set a record in terms of the number of approved securities class action settlements even if the total dollar amount falls short of last year.

The decline in total filings is driven by a sharp decline in new mergers and acquisitions filings, which are at the lowest level since the second half of 2014. Despite the decline in filings, 2021 has nonetheless already set a record for new SPAC-related filings by doubling both the 2020 and 2019 full-year totals in this category.

A. Filing Trends

Figure 1 below reflects filing rates for the first half of 2021 (all charts courtesy of Cornerstone Research). The first half of the year saw 112 new class action securities filings, a nearly 40% decrease from the same period last year and a 25% decrease from the second half of 2020. The decrease is largely driven by a drop in new M&A filings, from 64 and 35 in the two halves of 2020, respectively, to 12 in the first half of 2021. This represents a 66% decline in M&A filings from the second half of 2020, and 83% decline against the biannual average for M&A filings dating back through 2016.

Figure 1:

Semiannual Number of Class Action Filings (CAF Index^®)
January 2012 – June 2021

B. Industry and Other Trends in Cases Filed

Keeping with recent trends, new filings against consumer non-cyclical firms continued to make up the majority of new federal, non-M&A filings in the first half of 2021, as shown in Figure 2 below. New filings against communications and technology sector firms remained fairly steady, and an increase in filings against firms in the consumer cyclical and energy sectors partially offset the decline in filings against firms in the basic materials, industrial and financial sectors.

Figure 2:

Core Federal Filings by Industry
January 1997 – June 2021

As noted at the start and illustrated in Figure 3 below, the number of SPAC-related filings in the first half of 2021 exceeds those filed in both 2019 and 2020 combined. The increase is driven by filings in the consumer cyclical industry, and specifically, firms in the Auto manufacturers and Auto Parts & Equipment industries. In addition to notable activity in the SPAC space, cybersecurity-, cryptocurrency- and cannabis-related filings are all on pace to meet or exceed the 2020 totals, and 2021’s increased activity in ransomware attacks has already resulted in an uptick in cybersecurity filings in the second half of 2021. On the other hand, the majority of the new filings related to COVID-19 occurred earlier in the year, indicating that, as mentioned below, it is still too early to tell what the full year brings in terms of filings related to COVID-19.

Figure 3:

Summary of Trend Case Filings
January 2017 – June 2021

C. Settlement Trends

As shown in Figure 4, the total settlement dollars, adjusted for inflation, is down 72.7% against the same period last year despite a 35% increase in the number of settlements approved. Two settlements in the first half of 2021 exceeded $100 million, as compared to six such settlements last year and four in 2019, and the median value of approved settlements through the first half of the year is $7.9 million, reflecting an 18% decline against the same period last year. The difference between the magnitude of the decline in settlement amounts is likely driven by an outlier settlement in first half of last year.

Figure 4:

Total Settlement Dollars (in billions)
January 2016 – June 2021

II. What to Watch for in the Supreme Court

A. Supreme Court Issues Narrow Decision in Price-Impact Case

As we previewed in our 2020 Year-End Securities Litigation Update, in Goldman Sachs Group Inc. v. Arkansas Teacher Retirement System, 141 S. Ct. 1951 (2021), the Supreme Court this Term considered questions regarding price-impact analysis at the class-certification stage in securities class actions. Recall that in Halliburton Co. v. Erica P. John Fund, Inc., 573 U.S. 258 (2014) (“Halliburton II”), the Supreme Court preserved the “fraud-on-the-market” theory that enables courts to presume classwide reliance in Rule 10b-5 cases, but also permitted defendants to rebut that presumption with evidence that the alleged misrepresentation did not affect the issuer’s stock price.

Goldman Sachs presented the Court with the opportunity to decide how courts can address cases in which plaintiffs plead fraud through the “inflation maintenance” price impact theory, which claims that misstatements caused a preexisting inflated price to be maintained instead of causing the artificial inflation in the first instance. In granting certiorari, the Supreme Court accepted two questions for review: (1) “[w]hether a defendant in a securities class action may rebut the presumption of classwide reliance recognized in Basic Inc. v. Levinson, 485 U.S. 224 (1988), by pointing to the generic nature of the alleged misstatements in showing that the statements had no impact on the price of the security, even though that evidence is also relevant to the substantive element of materiality,” and (2) “[w]hether a defendant seeking to rebut the Basic presumption has only a burden of production or also the ultimate burden of persuasion.” Petition for a Writ of Certiorari at I, Goldman Sachs, 141 S. Ct. 1951 (No. 20-222).

In its June 21, 2021 decision, the Court declined to take a position on the “validity or . . . contours” of the inflation-maintenance theory in general, which it has never directly approved. Goldman Sachs, 141 S. Ct. at 1959 n.1. On the first question, the Court unanimously agreed with the parties that lower courts should hear evidence—including expert evidence—and rely on common sense to make determinations at the class-certification stage as to whether the alleged misrepresentations were so generic that they did not distort the price of securities. Id. at 1960. This analysis is permitted at the class-certification stage even though such evidence may also be relevant to the question of materiality, which is reserved for the merits stage. Id. at 1955 (citing Amgen Inc. v. Connecticut Ret. Plans and Tr. Funds, 568 U.S. 455, 462 (2013)). Importantly, the Court noted that in the context of an inflation-maintenance theory, the mismatch between generic misrepresentations and later, specific corrective disclosures will be a key consideration in the price-impact analysis. Goldman Sachs, 141 S. Ct. at 1961. “Under those circumstances, it is less likely that the specific disclosure actually corrected the generic misrepresentation, which means that there is less reason to infer front-end price inflation—that is, price impact—from the back-end price drop.” Id. The Court, with only Justice Sotomayor dissenting, then remanded the case for further consideration of the generic nature of the statements at issue here, explicitly directing the Second Circuit to “take into account all record evidence relevant to price impact, regardless whether that evidence overlaps with materiality or any other merits issue.” Id. (emphasis in original).

As to the second question, the Court held by a 6–3 majority that defendants at the class-certification stage bear the burden of persuasion on the issue of price impact in order to rebut the presumption of reliance—that is, to convince the court, by a preponderance of the evidence, that the challenged statements did not affect the price of securities. The Court determined that this rule had already been established by its previous decisions in Basic and Halliburton II: Basic recognized that defendants could rebut the presumption of classwide reliance by making “[a]ny showing that severs the link between the alleged misrepresentation and . . . the price,” and in Halliburton II, the Court again referenced defendants’ ability to rebut the Basic presumption with a “showing.” Id. at 1962 (internal citations omitted). The majority rejected an argument by the defendants, taken up by Justice Gorsuch (joined by Justices Thomas and Alito), that these references to a “showing” by the defense imposed only a burden of production. Id. at 1962; see also id. at 1965–70 (Gorsuch, J., concurring in part and dissenting in part). That reading would have allowed defendants to rebut the presumption of reliance “by introducing any competent evidence of a lack of price impact”—and would have imposed on plaintiffs the requirement to “directly prov[e] price impact in almost every case,” a requirement that had been rejected in Halliburton II. Id. at 1962–63 (emphasis in original). However, the Court noted that imposing the burden of persuasion on defendants would be unlikely to alter the outcome in most cases, as the “burden of persuasion will have bite only when the court finds the evidence is in equipoise—a situation that should rarely arise.” Id. at 1963.

B. Supreme Court to Decide whether the PSLRA’s Discovery Stay Applies in State Court

On July 2, 2021, just before its summer recess, the Court granted certiorari in Pivotal Software, Inc. v. Tran, No. 20-1541, which raises the question of whether the Private Securities Litigation Reform Act’s (“PSLRA”) discovery-stay provision applies to state court actions in which a private party raises a Securities Act claim. The PSLRA provides that the stay applies “[i]n any private action arising under” the Securities Act before a court has addressed a motion to dismiss, 15 U.S.C. § 77z-1-(b)(1), but state courts are sharply divided over whether the stay applies to suits in state court, rather than only to those in federal court. In opposition, respondent plaintiffs argued that not only is the issue moot (because they have agreed to adhere to the stay provision and the state court will have issued a decision on the motion to dismiss before the Supreme Court can issue an opinion), but also that no court of appeals has ever decided the issue. Brief in Opposition at 7–16, Pivotal Software, Inc. v. Tran, No. 20-1541. Petitioners countered that the issue will only ever arise in state courts and that state trial courts are divided, with at least a dozen decisions refusing to apply the stay and seven applying it, with many more decisions unreported. Moreover, the issue evades appellate review because it is time-sensitive and unlikely to affect a final judgment, rendering any error harmless. Reply Brief for Petitioners at 1–12, Pivotal Software, Inc. v. Tran, No. 20-1541.

Given the costs of discovery in securities actions, Pivotal could have a lasting impact on both the choice of forum in which securities actions are brought and on how discovery progresses in the early stages of a case.

C. The Court Addresses Constitutional Challenges to Administrative Adjudicators

Recall that in Lucia v. SEC, 138 S. Ct. 2044 (2018), the Court held that the SEC’s administrative law judges (“ALJs”) were “Officers of the United States” who must be appointed by the President, a court of law, or the SEC itself. Building on Lucia, the Supreme Court issued two decisions this Term that raised further questions on the constitutionality of administrative officers’ appointments.

Following Lucia, the petitioners in Carr v. Saul and Davis v. Saul sought judicial review of administrative decisions of the Social Security Administration (“SSA”), challenging in the district courts for the first time the constitutionality of SSA ALJ appointments. Carr v. Saul, 141 S. Ct. 1352, 1356–57 (2021). The district courts split on the question of whether petitioners had been required to raise their constitutional challenges during their administrative hearings in the first instance, but both the Eighth and Tenth Circuits agreed that the challenges had been forfeited. Id. at 1357. In its April 22, 2021 decision in these consolidated cases, the Supreme Court unanimously reversed, holding that the petitioners were not required to raise the appointments issue in SSA administrative proceedings, though the Justices were split in their reasoning. Id. at 1356.

The majority opinion held that the benefits claimants were not required to administratively exhaust the appointment issue, in the absence of any statutory or regulatory requirement, for three primary reasons. First, the Court had previously held that the SSA’s Appeals Council conducts proceedings that are more “inquisitorial” than “adversarial,” and that in the absence of “adversarial development of issues by the parties” before the agency tribunal, there was no basis for requiring a petitioner to raise all claims before the agency in order to preserve the issues for judicial review. Id. at 1358–59 (citing Sims v. Apfel, 530 U.S. 103, 112 (2000)). The Court applied the Sims rationale to SSA ALJs who, like the Appeals Council, conduct “informal, nonadversarial proceedings,” even though SSA ALJ proceedings may be considered “relatively more adversarial.” Id. at 1359–60. Second, as the Court has “often observed,” agency decision-makers “are generally ill suited to address structural constitutional challenges, which usually fall outside the adjudicators’ areas of technical expertise.” Id. at 1360. And third, the Court recognized that requiring issue exhaustion here would be futile as the agency adjudicators “are powerless to grant the relief requested.” Id. at 1361. The Court’s consolidated decision in Carr and Davis was dependent on features specific to the SSA’s review, so the question of whether issue exhaustion is required may be answered differently if it arises in future cases, either in the context of an agency with more adversarial administrative review procedures or if the constitutional challenge at issue is “[outside] the context of [the] Appointments Clause.” Id. at 1360 n.5.

In United States v. Arthrex, Inc., 141 S. Ct. 1970 (2021), the Court took up the question of whether administrative patent judges (“APJs”) in the Patent and Trademark Office (“PTO”) are “principal” or “inferior” officers under the Appointments Clause. (Readers should note that Gibson Dunn represented the private parties arguing alongside the government that APJs are inferior officers permissibly appointed by the Secretary of Commerce.) By a 5–4 vote, the majority held that the “unreviewable authority” of APJs to resolve inter partes review proceedings was incompatible with their appointment to an inferior office because “[o]nly an officer properly appointed to a principal office may issue a final decision binding the Executive Branch.” Id. at 1985.

In fashioning a remedy supported by seven Justices, the Court opted for a “tailored approach,” rather than striking down the entire inter partes review regime as unconstitutional. Id. at 1987. Specifically, the Court severed a provision of the statutory scheme that prevented the PTO Director from reviewing APJ decisions. Id. According to the Chief Justice, this remedy would align the Patent Trial and Appeal Board adjudication scheme with others in the Executive Branch and within the PTO itself. Id. In finding that the Constitutional violation is the restraint on the Director’s review authority rather than the APJs’ appointment by the Secretary, the Court found that the proper remedy was remand to the Director rather than to a new panel of APJs for rehearing. Id. at 1987–88.

The majority opinion drew opinions concurring and dissenting in part by Justice Gorsuch (objecting to the Court’s severability analysis) and Justice Breyer (joined by Justices Sotomayor and Kagan, agreeing with Justice Thomas’s analysis on the merits, but supporting the Court’s remedy), as well as a full dissent by Justice Thomas, who criticized the Court’s failure to take a clear position on whether APJs are inferior officers and whether their appointment complies with the Constitution. Id. at 1988–2011. He also disagreed with the Court’s modification of the statutory scheme because, in his view, APJs “are both formally and functionally inferior to the Director and to the Secretary,” and those officers already had sufficient control over APJs. Id. at 2011 (Thomas, J., dissenting).

III. Delaware Developments

**A. Court of Chancery Invalidates Poison Pill under Second Unocal Prong**

In February, the Court of Chancery in Williams Companies Stockholder Litigation, 2021 WL 754593 (Del. Ch. Feb. 26, 2021), enjoined a stockholder rights plan, also known as a “poison pill.” In March 2020, The Williams Companies, Inc. (“Williams”), a natural gas infrastructure company, adopted a stockholder rights plan after the company’s stock price declined substantially due to fallout from the COVID‑19 pandemic, which decreased demand and lowered prices in the global natural gas markets. Id. at *1. Williams adopted the plan in response to multiple perceived threats, including stockholder activism generally, concerns that activist investors may pursue disruptive, short-term agendas, and the potential for rapid and undetected accumulation of Williams stock (a “lightning strike”) by an opportunistic outside investor. Id. at *2.

The court employed the two-part Unocal standard of review to analyze whether (1) the Williams Board had a reasonable basis to implement a poison pill to respond to a legitimate threat, and (2) the reasonableness of the actual terms of the poison pill in relation to the threat posed. Id. at *22 (citing Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985)). Assuming for the sake of analysis that the “lightning strike” concern constituted a legitimate corporate objective, the court held that the plan’s terms were unreasonable. Id. at *33–34. The plan included a triggering ownership threshold of just 5%, compared to a typical market range of 10% to 15%. Id. at *35–36. It also contained an expansive definition of “beneficial ownership” that covered even synthetic interests, an expansive definition of “acting in concert” that covered any parallel conduct by multiple parties, and a relatively narrow definition of the term “passive investor,” which limited the number of investors exempt from the plan’s provisions. Id. at *35. The court concluded that the combined impact of these terms went well beyond that of comparable rights plans and could impermissibly stifle legitimate stockholder activity. Id. at *35–40. Notably, the court looked beyond the stated rationales listed in board resolutions, board minutes, and company disclosures, and instead sought to determine the actual intent of the directors based on testimony and other evidence. Id. The ruling offers an important reminder that rights plans have limits and that the Court of Chancery will not hesitate to assess a board’s subjective basis for implementing a rights plan and its specific terms.

B. Court of Chancery Rejects Claim that Pandemic Constituted a Materially Adverse Effect

In April, the Court of Chancery in Snow Phipps Group, LLC v. KCake Acquisition, Inc., 2021 WL 1714202 (Del Ch. Apr. 30, 2021), rejected a claim that the COVID‑19 pandemic constituted a material adverse effect (“MAE”) under the agreement at issue. There, a private equity firm buyer signed a $550 million agreement with Snow Phillips to purchase DecoPac, a company that supplies cake decorations and equipment to grocery stores. Id. at *1, *9–10. The deal coincided with the early months of the COVID-19 pandemic, which caused a significant decline in DecoPac’s sales. Id. at *1–2. The buyer subsequently attempted to terminate the agreement when it was unable to secure financing based on the target’s revised sales projections. Id. at *24–25.

In the ensuing litigation, the buyer alleged that DecoPac breached a representation that no change or development had, or “would reasonably be expected to have,” an MAE on DecoPac’s finances. Id. at *10. The court rejected this argument, observing—consistent with Delaware precedent—that the existence of an MAE must be judged in terms of DecoPac’s long-term financial prospects (measured in “years rather than months”). Id. at *30. Further, the court noted that the reduction in sales fell within a carve-out from the MAE representation, namely, effects arising from changes in laws or governmental orders. Id. at *35. The decision is notable not just for reaffirming the difficulty of invoking MAE clauses, but also for its broad discussion of how MAE clause carve-outs might negate the occurrence of an existing MAE.

C. Bellwether SPAC Litigation Remains in Initial Stages

In June, the defendants in In re MultiPlan Corp. Stockholders Litigation, Cons. C.A. No. 2021-0300-LWW, filed their motion to dismiss a closely watched consolidated class action filed by the stockholders of MultiPlan, a provider of cost management technology services to insurance agencies. MultiPlan was partially acquired in October 2020 via a reverse merger with a Special Purpose Acquisition Company (“SPAC”), Churchill Capital Corp. III. Most notably, the complaint contends that SPAC structures create inherent conflicts, alleging that MultiPlan’s business prospects have weakened and its stock price has decreased approximately 30% since the acquisition, but the personal investments of individuals managing the SPAC entity have increased materially. The plaintiff stockholders accuse the SPAC, its sponsor, and other directors of issuing misleading and deficient disclosures and of grossly mispricing the transaction.

Although some commentators have characterized the case as a bellwether and the claims asserted as novel, the defendants’ motion to dismiss tracks familiar arguments for attacking complaints concerning merger transactions at the pleading stage. For example, the defendants characterize the claims as derivative and urge dismissal for failure to make a demand. The defendants alternatively assert that, if the claims are direct, they are subject to the business judgment rule and warrant dismissal. More notably, the defendants contend that claims regarding plaintiffs’ redemption rights cannot proceed as fiduciary duty claims because they arise solely from contract. A decision on the pending MultiPlan motion to dismiss may have significant implications for the very active SPAC market, as the Court of Chancery weighs in on the efficacy of these entities and any implications their structure may have for deal disclosures.

D. Court of Chancery Determines CEO Breached Fiduciary Duty and Financial Advisor Aided and Abetted That Breach in Course of Executing a Merger

In Firefighters’ Pension System of the City of Kansas City, Missouri Trust v. Presidio, Inc., 2021 WL 298141 (Del. Ch. Jan. 29, 2021), the Court of Chancery denied motions to dismiss by Presidio’s CEO for allegedly breaching his fiduciary duty and Presidio’s financial advisor for allegedly aiding and abetting that breach, but dismissed claims against the controlling stockholder and other board members. The class action suit challenged a merger of Presidio, a controlled company, with an unaffiliated third party. The court held that a number of actions the CEO allegedly took, if credited, would yield an unreasonable sales process under Revlon. Id. at 267–68. For example, the court credited allegations that the CEO inappropriately steered the bidding process in favor of a private equity buyer that was more eager to retain existing management and simultaneously downplayed to the board of directors the interests of a strategic bidder. Although the strategic bidder allegedly had the capability to pay a higher price as a result of the synergies, it was more likely to replace the CEO. Id. at 267. The court also credited allegations that Presidio’s financial advisor had tipped the potential private equity buyer to confidential information that enabled it to structure its proposed terms into the ultimately bid-winning offer. Id. Presidio has the potential to serve as informative precedent for transactions entailing potential post-close employment opportunities for executives who guide the company’s sale process.

E. Appraisal Litigation Continues Its Steady Decline

The frequency of appraisal litigation continues to decline, with just four appraisal actions filed in the Delaware Court of Chancery in the first half of 2021, compared to the 13 actions filed in the first half of 2020. Going forward, we expect to see appraisal actions concentrated to a subset of deals involving alleged conflicts, process issues, or a limited market check.

Recent appraisal actions that have proceeded continue to reinforce the rulings in DFC Global Corp. v. Muirfield Value Partners, L.P., 172 A.3d 346 (Del. 2017) and Dell, Inc. v. Magnetar Global Event Driven Master Fund Ltd., 177 A.3d 1 (Del. 2017): objective market evidence—including deal price (potentially less synergies) and unaffected market price—generally provides the best indication of a company’s fair value. In In re Appraisal of Regal Entertainment Group, 2021 WL 1916364 (Del. Ch. May 13, 2021), for example, the Court of Chancery awarded a relatively modest 2.6% increase over the original merger price. The court held that the best evidence of the target’s fair value was the deal price, adjusted for post-signing value increases. Id. at *58. The court rejected arguments that Regal’s stock price was the best indicator of fair value, finding that “the sale process that led to the Merger Agreement was sufficiently reliable to make it probable that the deal price establishes a ceiling for the determination of fair value.” Id. at *34.

In the absence of reliable market-based indicators, the Court of Chancery has demonstrated a willingness to fall back on potentially more subjective valuation techniques, including discounted cash flow and comparable company analyses. In January 2021, the Delaware Supreme Court affirmed a Court of Chancery decision awarding a 12% premium on the merger price based solely on a discounted cash flow (“DCF”) valuation. SourceHOV Holdings, Inc. v. Manichaean Capital, LLC, 246 A.3d 139 (Del. 2021). The Court of Chancery’s exclusive use of the petitioner’s DCF valuation was premised on the Respondent’s failure to prove a fair value for the transaction, with the court noting it was “struck by the fact that [Respondent] disagreed with its own valuation expert, relied on witnesses whose credibility was impeached and employed a novel approach to calculate SourceHOV’s equity beta that is not supported by the record evidence. In a word, Respondent’s proffer of fair value is incredible.” Manichaean Capital, LLC v. SourceHOV Holdings, Inc., 2020 WL 496606, at *2 (Del. Ch. Jan. 30, 2020).

IV. Further Development of Disseminator Liability Theory Upheld in Lorenzo

As we initially discussed in our 2019 Mid-Year Securities Litigation Update, in March 2019, the Supreme Court held in Lorenzo v. SEC, 139 S. Ct. 1094 (2019), that those who disseminate false or misleading information to the investing public with the intent to defraud can be liable under Section 17(a)(1) of the Securities Act and Exchange Act, Rules 10b-5(a) and 10b-5(c), even if the disseminator did not “make” the statement within the meaning of Rule 10b-5(b). In practice, Lorenzo creates the possibility that secondary actors—such as financial advisors and lawyers—could face liability under Rules 10b-5(a) and 10b-5(c) (known as the “scheme liability provisions”) simply for disseminating the alleged misstatement of another, if a plaintiff can show that the secondary actor knew the alleged misstatement contained false or misleading information.

In 2021, courts have continued to grapple with Lorenzo’s application, particularly “whether Lorenzo’s language can be read to stretch scheme liability to cases in which plaintiffs are specifically alleging that the defendant did ‘make’ misleading statements (or omissions) as prohibited in Rule 10b5-(b),” or if “Lorenzo merely extends scheme liability to those who ‘disseminate false or misleading statements’ but that it does not hold that ‘misstatements [or omissions] alone are sufficient to trigger scheme liability’” absent additional conduct. Puddu v. 6D Global Techs., Inc., 2021 WL 1198566, at *10 (S.D.N.Y. Mar. 30, 2021) (quoting SEC v. Rio Tinto PLC, 2021 WL 818745, at *2 (S.D.N.Y. Mar. 3, 2021)) (summarizing the divergent views of various district courts).

In June, the Ninth Circuit, in In re Alphabet, Inc. Securities Litigation, 1 F.4th 687 (9th Cir. 2021) (“Alphabet”), signaled its support for the view that disseminator liability does not require “conduct other than misstatements.” Alphabet involved allegations that executives at Google and its holding company, Alphabet, were aware of security vulnerabilities on the Google+ social network. Id. at 693–97. Plaintiffs brought a claim against Alphabet under Rule 10b-5(b), in addition to scheme liability claims under Rule 10b-5(a) and (c), alleging a scheme to defraud shareholders by withholding material and damaging information about the security vulnerabilities from Alphabet’s quarterly filings. See id. at 698. The district court granted Alphabet’s motion to dismiss in full, finding that plaintiffs had failed to adequately allege a misrepresentation or omission of a material fact and failed to adequately allege scienter for the purposes of their Rule 10b-5 claims. Id.

On appeal, the Ninth Circuit reversed in part, holding that that the trial court erred by dismissing the claims under Rule 10b-5(a) and (c) because defendants had not specifically moved to dismiss those claims but instead moved to dismiss only on the basis of Rule 10b-5(b) and Rule 10b-5 generally. Id. at 709. Notably, the panel also disagreed with Alphabet’s “argument that Rule 10b-5(a) and (c) claims cannot overlap with Rule 10b-5(b) statement liability claims” because such an argument “is foreclosed by Lorenzo, which rejected the petitioner’s argument that Rule 10b-5(a) and (c) ‘concern “scheme liability claims” and are violated only when conduct other than misstatements is involved.’” Id. (quoting Lorenzo, 139 S. Ct. at 1101–02).

At the same time, district courts within the Second Circuit are considering the breadth of Lorenzo. See In re Teva Sec. Litig., 2021 WL 1197805, at *5 (D. Conn. Mar. 30, 2021) (summarizing the divergent views). As the Teva court explained, “[s]ome district courts in this circuit apparently agree with the” view that Lorenzo “abrogated the rule that ‘scheme liability depends on conduct that is distinct from an alleged misstatement,’” “[b]ut other district courts cabin Lorenzo and read it more restrictively” to only hold that “‘those who disseminate false or misleading statements to potential investors with the intent to defraud can be liable under [Rule 10b-5(a) and (c)], not that misstatements alone are sufficient to trigger scheme liability.’” Id. (quoting Rio Tinto PLC, 2021 WL 818745, at *2–3).

The Second Circuit itself has not yet squarely addressed the scope of Lorenzo. However, earlier this year, the district court in SEC v. Rio Tinto PLC, 2021 WL 1893165 (S.D.N.Y. May 11, 2021), certified an interlocutory appeal to the Second Circuit, following its dismissal of scheme liability claims where the SEC failed to “allege that Defendants disseminated [the] false information, only that they failed to prevent misleading statements from being disseminated by others.” At the time of this update, the Second Circuit had not ruled on whether it will hear the appeal. Gibson Dunn represents Rio Tinto in this and other litigation.

As these developments suggest, the application of the Lorenzo disseminator liability theory continues to evolve among and within the circuits. We will continue to monitor closely the changing applications of Lorenzo and provide a further update in our 2021 Year-End Securities Litigation Update.

Although the stock market has largely stabilized since COVID-19 first impacted the United States in 2020, courts are still feeling the effects of the economic disruption and attendant securities litigation arising out of the pandemic. While the first series of COVID-19 securities lawsuits focused on select industries, such as travel and healthcare, plaintiffs eventually set their sights on other industries. We surveyed a select number of these cases in our 2020 Year-End Securities Litigation Update.

Since then, there have been several dismissals of COVID-19-related securities cases, including dismissals of some of the earliest cases brought in March 2020 concerning the travel industry. Nevertheless, lawsuits for misstatements regarding safety and risk disclosures are still being brought, and now that the “Delta” variant has spread throughout the United States, such lawsuits may continue for the foreseeable future.

Although it is too soon to tell whether the midpoint of COVID-19 securities litigation has passed, we will continue to monitor developments in this area. Additional resources regarding the legal impact of COVID-19 can be found in the Gibson Dunn Coronavirus (COVID-19) Resource Center.

A. Securities Class Actions

1. False Claims Concerning Commitment to Safety

Douglas v. Norwegian Cruise Lines, No. 20-cv-21107, 2021 WL 1378296 (S.D. Fla. Apr. 12, 2021): As we discussed in our 2020 Mid-Year Securities Litigation Update, the COVID-19 pandemic birthed an entire category of class action lawsuits concerning service companies’ commitments to safety, including a proposed class action lawsuit against Norwegian Cruise Lines. In April 2021, Judge Robert Scola, Jr. dismissed the lawsuit, which had originally alleged that Norwegian violated securities laws by minimizing the impact of the COVID-19 outbreak on its operations and failing to disclose allegedly deceptive sales practices that downplayed COVID-19. Id. at *2–3. Judge Scola, Jr. concluded that “[a]ll the challenged statements constitute corporate puffery” such that no reasonable investor would have relied on them. Id. at *4.

In re Carnival Corp. Securities Litigation, No. 20-cv-22202, 2021 WL 2583113 (S.D. Fla. May 28, 2021): Similarly, in May 2021, a year after plaintiffs filed the complaint, Judge K. Michael Moore dismissed a putative class action against Carnival that alleged that Carnival misrepresented the effectiveness of its health and safety protocols during the COVID-19 outbreak. Id. at *1–3. The court held that the plaintiffs-investors had failed to show that Carnival’s “statements affirming compliance with then-existing regulatory requirements [were] materially false or misleading” because the plaintiffs’ argument relied on the inference that “passengers would ultimately fall ill aboard Carnival’s ships—just as people did in other venues across the globe.” Id. at *15. Accordingly, the court found the inference was “too tenuous to meet the heightened pleading standard applicable in the securities fraud context.” Id.

2. Failure to Disclose Specific Risks

Plymouth Cnty. Retirement Assoc. v. Array Techs., Inc., No. 21-cv-04390 (S.D.N.Y. May 14, 2021): Plaintiffs allege that Array, a solar panel manufacturer, along with several of its directors and underwriters, failed to disclose that “unprecedented” increases in steel and shipping costs negatively impacted the company’s quarterly results until the company’s CFO revealed the results in a conference call. Dkt. No. 1 at ¶¶ 10–42, 113–15. Upon the release of this news, Array’s stock price fell by $11.49 to close at $13.46. Id. at ¶ 118. Array had previously issued warnings on the “global shipping constraints due to COVID-19” but allegedly failed to disclose the impact of dramatically increasing supply prices and increasing freight costs. Id. at ¶¶ 103, 112. This case was later consolidated with Keippel v. Array Technologies, Inc., 21-cv-5658 (S.D.N.Y. June 30, 2021). Dkt. No. 61 at 1. The case remains pending.

Denny v. Canaan Inc., No. 21-cv-03299 (S.D.N.Y. Apr. 15, 2021): A shareholder of Canaan, a company that manufactures and sells Bitcoin mining machines, alleged that the company misleadingly issued positive statements about strong demand for bitcoin mining machines without disclosing how “ongoing supply chain disruptions” and the introduction of its latest machines had “cannibalized sales of [its] older product offerings,” which caused sales to decline. Dkt No. 1 at ¶ 4. Purportedly, Canaan did not reveal these issues until a conference call to discuss fourth quarter earnings, after which Canaan’s American Depository Receipts, which are a type of securities, declined by nearly 30%. Id. at ¶¶ 27–28.

3. Alleged Insider Trading and “Pump and Dump” Schemes

Tang v. Eastman Kodak Co., No. 20-cv-10462 (D.N.J. Aug. 13, 2020): In our 2020 Year-End Securities Litigation Update, we previously discussed this putative class action, in which stockholders contended Eastman Kodak violated securities law by failing to disclose that its officers were granted stock options prior to the company’s public announcement that it had received a loan to produce drugs for the treatment of COVID-19. Dkt. No. 1 at 2. On May 28, the New Jersey federal judge transferred the case to the Western District of New York, where the alleged misconduct occurred. Dkt. No. 62 at 1. In parallel, New York Attorney General Leticia James commenced an action under Section 34 of General Business Law to seek evidence of insider trading from Kodak. NYSCEF No. 451652/2021, Dkt. No. 1 at 1. On June 15, the court ordered Kodak’s executives to publicly testify. Dkt. No. 9 at 2.

B. Stockholder Derivative Actions

1. Disclosure Liability

Berndt v. Kelly, No. 21-cv-50422 (W.D. Wash. June 4, 2021): In this derivative suit, plaintiff alleges that CytoDyn Inc., which is developing a drug with potential benefits for HIV patients, misleadingly touted the drug as a potential COVID-19 treatment, resulting in a significant increase in the company’s stock price. Dkt. No. 1 at ¶¶ 2–4. “[W]hile the [c]ompany’s stock price was sufficiently inflated with the COVID-19 cure hype,” the complaint alleges, a close circle of long-term shareholders “dumped millions of shares.” Id. at ¶ 6. Following the alleged cash-out of company shares, the price of CytoDyn “dropped precipitously” after it was revealed that the COVID-19 treatment was not commercially viable. Id. at ¶ 8. The suit includes claims for breach of fiduciary duty, waste of corporate assets, unjust enrichment, and violations of the Exchange Act. Id. at ¶¶ 78–98.

Golubinski v. Douglas, No. 2021-0172 (Del. Ch. Apr. 20, 2021): An investor of Novavax Inc. derivatively sued the company’s directors and certain officers, claiming that they granted themselves a series of lucrative equity awards in 2020 with the knowledge that Novavax’s stock was going to increase nearly 700% based on promising COVID-19 vaccine news. Dkt. 1 at ¶¶ 5–13. The investor alleges that “management exploited its relationships with regulators and influential players in the vaccine community to both secure funding and position itself to receive even more funding for COVID-19 research prior to granting spring-loaded awards to [c]ompany insiders.” Id. at ¶ 15. The stock granted to executives in April and June 2020 allegedly rose in value within a few months, after the news became public that the company would be getting billions in funding through Operation Warp Speed, the U.S. government’s COVID-19 vaccine initiative. Id. at ¶¶ 9–13. The derivative suit seeks, among other things, to have the stock awards rescinded. Id. at ¶ 16.

2. Oversight Liability

Bhandari v. Carty, No. 2021-0090 (Del. Ch. Feb. 5, 2021): Two stockholders of YRC Worldwide, Inc. sued the company’s directors, claiming that they oversaw a fraudulent scheme to overcharge customers for freight cargo, and then sought a $700 million government bailout purportedly justified by fraudulent concerns relating to COVID-19. Dkt. 1 at ¶¶ 3–15. The bailout, which plaintiffs allege “made the company one of the largest recipients of taxpayer money meant to support businesses and workers struggling amid the coronavirus,” has now “come under scrutiny from” Congress, which is investigating whether it “was really worthy of a rescue,” according to the complaint. Id. at ¶ 15. Plaintiffs allege that the board “could and should have quickly and responsibly taken action to correct management’s wrongdoing,” but failed to do so. Id. at ¶ 5.

3. Insider Trading

Lincolnshire Police Pension Fund v. Kramer, No. 21-cv-01595 (D. Md. June 29, 2021): Plaintiff sued directors of Emergent BioSolutions Inc. derivatively for claims that the board members allegedly sold a combined $20 million of personally held Emergent shares “on the basis of the nonpublic information about the problems at the Bayview Facility,” where the company was working on a COVID-19 vaccine for Johnson and Johnson. Dkt. 1 at ¶¶ 9, 15–26, 89, 101. The fund claims that the directors allegedly “used their knowledge of Emergent’s material, nonpublic information to sell their personal holdings while the Company’s stock was artificially inflated.” Id. at ¶ 89. Specifically, the allegations are that the directors were supposedly aware of Bayview’s history of internal control failures and inability to handle the “massive and critical work required to manufacture [the COVID-19] vaccines.” Id. at ¶ 3.

In Delaware, another Emergent stockholder brought a Section 220 action against Emergent to enforce his statutory right to inspect the company’s books and records. See Elton v. Emergent BioSolutions, Inc., No. 2021-0426 (Del. Ch. May 21, 2021). There, too, the stockholder alleged that there was a “credible basis to infer the Company’s fiduciaries sold Company stock while in possession of material, non-public information” relating to Emergent’s alleged “regulatory, compliance, and manufacturing failures.” Dkt. 1 at ¶ 3.

C. SEC Cases

SEC v. Arrayit Corp., No. 21-cv-01053 (N.D. Cal. Feb. 11, 2021): As we discussed in our 2020 Year-End Securities Litigation Update, the SEC charged Mark Schena, the President of Arrayit Corporation, a healthcare technology company, for “making false and misleading statements about the status of Arrayit’s delinquent financial reports.” SEC v. Schena, No. 20-cv-06717 (N.D. Cal. Sept. 25, 2020), Dkt. No. 1 at ¶ 1. That case was stayed, pending the resolution of a criminal case against Mr. Schena. Dkt. 23. Since then, the SEC has brought a separate case against Arrayit itself, as well as Mark Schena’s wife, who served as Arrayit’s CEO, CFO, and chairman for over a decade. No. 5:21-cv-01053, Dkt. No. 1 at ¶¶ 1, 11. The new claims brought under Sections 10(b) and 13(a) mirror those in the prior action against Mr. Schena, namely that the defendants allegedly misrepresented the company’s capability to develop COVID-19 tests. Id. at ¶ 1. The parties settled on a neither-admit-nor-deny basis, with Ms. Schena also agreeing to a $50,000 penalty. Dkt. No. 11 at 1–3; Dkt No. 12 at 2.

SEC v. Parallax Health Sciences, Inc., No. 21-cv-05812 (S.D.N.Y. July 7, 2021): This enforcement action, brought under Section 17(a)(1)(3) of the Securities Act and Section 10(b) of the Exchange Act, resulted from a series of seven press releases issued by Parallax, a healthcare company, about its ability to capitalize on the COVID-19 pandemic. Dkt. No. 1 at ¶¶ 1, 4. The SEC’s complaint alleges that Parallax falsely claimed that its COVID-19 screening test would be “available soon” despite the company’s insolvency and the company’s own internal projections showing that, even if it had the funds, other factors prevented the company from acquiring the needed equipment. Id. at ¶¶ 1–2. Parallax, its CEO, and CTO settled with the SEC on a neither-admit-nor-deny basis, and agreed to penalties of $100,000, $45,000, and $40,000, respectively. Dkt. No. 4 at 1, 4.

SEC v. Wellness Matrix Grp., Inc., No. 21-cv-1031 (C.D. Cal. June 11, 2021): The SEC charged Wellness Matrix, a wellness company, and its controlling shareholder for allegedly misleading investors about the availability and approval status of its at-home COVID-19 testing kits and disinfectants in violation of Section 10(b) and Rule 10b-5. Dkt. No. 1 at ¶¶ 6–7, 9. The SEC alleges that the company’s claims were false and, to the contrary, defendants knew its distributor was unable to fulfill the order and the products were neither FDA- nor EPA-approved. Id. at ¶¶ 44–48. The SEC had suspended trading in Wellness Matrix’s securities approximately two months before bringing the action. Id. at ¶ 68.

VI. Falsity of Opinions – Omnicare Update

As we discussed in our prior securities litigation updates, lower courts continue to examine the standard for imposing liability based on a false opinion as set forth by the Supreme Court in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, 575 U.S. 175 (2015). In Omnicare, the Supreme Court held that “a sincere statement of pure opinion is not an ‘untrue statement of material fact,’ regardless whether an investor can ultimately prove the belief wrong,” but that an opinion statement can form the basis for liability in three different situations: (1) the speaker did not actually hold the belief professed; (2) the opinion contained embedded statements of untrue facts; or (3) the speaker omitted information whose omission made the statement misleading to a reasonable investor. Id. at 184–89.

In 2021, federal courts have continued to grapple with whether Omnicare—which was decided in the context of a Section 11 claim—applies to claims brought under the Exchange Act. In April, the Ninth Circuit extended the Omnicare standard to claims brought under Exchange Act Section 14(a) and Rule 14a-9. Golub v. Gigamon Inc., 994 F.3d 1102, 1107 (9th Cir. 2021). The court reasoned that such claims contain a “virtually identical limitation on liability” to claims under Section 11 and Rule 10b-5, to which the Ninth Circuit held Omnicare applies. Id.; see also City of Dearborn Heights Act 345 Police & Fire Ret. Sys. v. Align Tech., Inc., 856 F.3d 605 (9th Cir. 2017).

Two additional cases addressing Omnicare’s application to the Exchange Act came down in the District of New Jersey, with one of them ultimately deciding to apply the Omnicare standard for falsity to claims brought under Section 10(b) and Rule 10b-5. Ortiz v. Canopy Growth Corp., No. 2:19-cv-20543, 2021 WL 1967714 (D.N.J. May 17, 2021). Recognizing the majority view outside the Third Circuit that Omnicare applies to such claims, the court in Ortiz “s[aw] no reason to apply a different rule.” Id. at *33. However, after finding that the alleged statements were actionable under Omnicare, the court still dismissed the complaint for failure to plead scienter. Id. at *44. While plaintiffs adequately pled that defendants did not believe certain statements when they were made and misleadingly omitted certain material facts, plaintiffs could not overcome the PLSRA’s high bar for scienter. Id. at *38–39. The court found that plaintiffs failed to plead facts to support a “strong inference” of scienter because, based on several factors, another more “innocent explanation” was plausible. Id. at *42–43. In another case, a District of New Jersey court found evaluation of Omnicare unnecessary for the same reason: Plaintiffs did not plead facts to “support a ‘strong inference’ of scienter.” In re Amarin Corp. PLC Sec. Litig., No. 3:19-cv-06601, 2021 WL 1171669 at *19 (D.N.J. Mar. 29, 2021). These cases suggest Omnicare may rarely be outcome-determinative for Section 10(b) and Rule 10b-5 claims because opinions that may be actionable under Omnicare may often lack an “intent to deceive, manipulate, or defraud,” as required to demonstrate scienter. See Ortiz, 2021 WL 1967714, at *10.

Omnicare has remained a significant pleading barrier in the first half of 2021. In Salim v. Mobile Telesystems PJSC, No. 19-cv-1589, 2021 WL 796088 (E.D.N.Y. Mar. 1, 2021), the Eastern District of New York held that a statement about potential liability resulting from investigations into alleged FCPA violations “would have necessarily been a statement of opinion until the company could give a reasonable estimate of its potential losses.” Because plaintiff failed to allege sufficient facts to show that defendant did not actually believe what it stated, the court granted defendants’ motion to dismiss. Id. at *8–9. Similarly, in City of Miami Fire Fighters’ and Police Officers’ Retirement Trust v. CVS Health Corp., the District of Rhode Island held that reported results of goodwill assessments conducted under Generally Accepted Accounting Principles are opinion statements that must be assessed under Omnicare because “[e]stimates of goodwill depend on management’s determination of the fair value of the assets acquired and liabilities assumed, which are not matters of objective fact.” No. 19-437-MSM-PAS, 2021 WL 515121, at *9 (D.R.I. Feb. 11, 2021). In granting defendants’ motion to dismiss, the court found allegations “amount[ing] to a retrospective disagreement with [defendant’s] judgment” inadequate “without sufficient facts to undermine the assumptions [defendant] used when it made its goodwill assessments.” Id. at *10.

Other recent district court decisions illustrate the narrow situations in which plaintiffs have overcome Omnicare’s high bar. For instance, in Howard v. Arconic Inc., defendants argued that aluminum manufacturer Arconic’s statement that it “believes it has adopted appropriate risk management and compliance programs to address and reduce” certain risks was a non-actionable opinion under Omnicare. No. 2:17-cv-1057, 2021 WL 2561895, at *7 (W.D. Pa. June 23, 2021). The court disagreed, holding that the statement “conveyed to investors that there was a reasonable basis for [defendants’] belief about the adequacy of the compliance/risk management programs,” but facts regarding Arconic’s practice of selling hazardous products “call[ed] into question the reasonableness of that belief.” Id.

Finally, in SEC v. Bluepoint Investment Counsel, LLC, the SEC claimed that the investment-advisor defendants had defrauded investors by reporting misleading and unreasonable valuations of fund assets in order to charge excessive management and other fees. No. 19-cv-809, 2021 WL 719647, at *1 (W.D. Wis. Feb. 24, 2021). The court held that the statements were actionable, consistent with Omnicare, because “the SEC has alleged specific facts which, taken as true, involve valuations containing embedded statements of fact that were untrue.” Id. at *17. Specifically, defendants had stated that the valuations would be “based on underlying market driven events,” but the SEC alleged that the appraisal process was far less thorough. Id. This method, the court reasoned, “reflects the kind of ‘baseless, off-the-cuff judgment[]’ that an investor reasonably would not expect in the context of a third-party appraisal that is then relied upon in an investor fund’s financial statements.” Id.

As shareholder litigation arising from the economic impact of COVID-19 continues, including a handful of cases targeting vaccine development and efficacy, Omnicare will likely play a significant role. See Complaint for Violations of the Federal Securities Law, In re AstraZeneca PLC Sec. Litig., No. 1:21-cv-00722 (S.D.N.Y. Jan. 26, 2021) (containing various allegations based on statements or omissions relating to clinical trials for the COVID-19 vaccine). Disclosures and accounting estimates impacted by the rapidly evolving circumstances presented by the pandemic, and other statements and estimates involving interpretation of complex scientific data, are at the heart of Omnicare analysis. We will continue to monitor developments in these and similar cases.

VII. Halliburton II Market Efficiency and “Price Impact” Cases

As previewed in our last two updates, and discussed above in our Supreme Court roundup, the Supreme Court issued its decision in Goldman Sachs Group, Inc. v. Arkansas Teacher Retirement System on June 21. 141 S. Ct. 1951 (2021) (“Goldman Sachs”). Practitioners now have confirmation from the Supreme Court that courts must consider the generic nature of allegedly fraudulent statements at the class certification stage when necessary to determine whether the statements impacted the issuer’s stock price, even though that analysis will often overlap with the merits issue of materiality. See id. at 1960–61. The Court also resolved the question of which party bears what burden when defendants offer evidence of a lack of price impact to rebut the presumption of reliance, placing the burdens of both production and persuasion on defendants. See id. at 1962–63.

Recall that in Halliburton Co. v. Erica P. John Fund, Inc., 573 U.S. 258 (2014) (“Halliburton II”), the Supreme Court preserved the “fraud-on-the-market” presumption of class-wide reliance in Rule 10b-5 cases, but also permitted defendants to rebut this presumption at the class certification stage with evidence that the alleged misrepresentation did not impact the issuer’s stock price. Since that decision, as we have detailed in these updates, lower courts have struggled with several recurring questions, including: (1) how to reconcile Halliburton II with Erica P. John Fund, Inc. v. Halliburton Co., 563 U.S. 804 (2011) (“Halliburton I”) and Amgen Inc. v. Connecticut Retirement Plans and Trust Funds, 568 U.S. 455 (2013), in which the Court held that loss causation and materiality, respectively, were not class certification issues, but instead should be addressed at the merits stage; (2) who bears what burden when defendants present evidence of a lack of price impact; and (3) what evidence is sufficient to rebut the presumption. The Court has now resolved the first two questions in Goldman Sachs.

In its most recent decision, the Second Circuit held that the generic nature of Goldman Sachs’s allegedly fraudulent statements was irrelevant at the class-certification stage and instead should be litigated at trial, and that defendants bore both the burden of production and persuasion in rebutting the presumption of reliance. Ark. Tchr. Ret. Sys. v. Goldman Sachs Grp., Inc., 955 F.3d 254, 265–74 (2d Cir. 2020). As detailed above, the Supreme Court disagreed with the first holding but agreed with the second. Because it was unclear whether the Second Circuit properly considered Goldman Sachs’s price impact evidence, the Court remanded for further consideration. Goldman Sachs, 141 S. Ct. at 1961. The Court also confirmed that the Second Circuit allocated the parties’ burdens correctly, because the defendant “bear[s] the burden of persuasion to prove a lack of price impact by a preponderance of the evidence,” including at the class-certification stage. Id. at 1958. The Court clarified that its opinions had already placed that burden on defendants—although “the allocation of burden is unlikely to make much difference on the ground,” and will “have bite only when the court finds the evidence in equipoise.” Id. at 1963.

Most importantly, an eight-justice majority made clear that even when the question of price impact overlaps with merits questions, all relevant evidence on price impact must be considered at the class certification stage. Goldman Sachs, 141 S. Ct. at 1960–61 (citing Halliburton II, Comcast Corp. v. Behrend, 569 U.S. 27 (2013), and Wal-Mart Stores, Inc. v. Dukes, 564 U.S. 338 (2011)). This is the case even though “materiality and price impact are overlapping concepts” and “evidence relevant to one will almost always be relevant to the other.” Id. at 1961 n.2. In other words, the Supreme Court has now confirmed that Halliburton I, Amgen, and Halliburton II are consistent because plaintiffs do not need to prove materiality and loss causation to invoke the presumption of reliance, but defendants can use price impact evidence—including evidence of immateriality or a lack of loss causation—to defeat the presumption of reliance at the class certification stage.

Despite its relevance to the case, the Court declined to offer a view on the validity of the inflation-maintenance theory, under which plaintiffs frequently argue that price movements associated with negative news can be attributed to earlier, challenged statements. See id. at 1959 n.1. However, the Court underscored that the connection between a statement and a corrective disclosure is particularly important in inflation-maintenance cases. Id. at 1961. As the Court noted, the inference that a subsequent price drop proves there was previous inflation “starts to break down when there is a mismatch between the contents of the misrepresentation and the corrective disclosure,” which can occur “when the earlier misrepresentation is generic . . . and the later corrective disclosure is specific.” Id.

The Second Circuit has now remanded to the district court to examine all relevant evidence of price impact in the first instance. Arkansas Tchr. Ret. Sys. v. Goldman Sachs Grp., Inc., No. 18-3667, 2021 WL 3776297, at *1 (2d Cir. Aug. 26, 2021). We will continue to monitor this and related cases.

VIII. Other Notable Developments

A. Morrison Domestic Transaction Test

The circuit split concerning the application of the domestic transaction test from Morrison v. National Australia Bank Ltd., 561 U.S. 247 (2010), has widened in the first half of this year. In Morrison, the Supreme Court held that the Exchange Act only applied to “transactions in securities listed on domestic exchanges, and domestic transactions in other securities.” Id. at 267. This holding was premised on “the focus of the Exchange Act,” which is “not upon the place where the deception originated, but upon purchases and sales of securities in the United States.” Id. at 266. Thereafter, courts have held that a security that is not traded on a domestic exchange satisfies the second prong of Morrison, “if irrevocable liability is incurred or title passes within the United States.” Absolute Activist Value Master Fund Ltd. v. Ficeto, 677 F.3d 60, 67 (2d Cir. 2012).

This January, in Cavello Bay Reinsurance Ltd. v. Shubin Stein, 986 F.3d 161 (2d Cir. 2021), the Second Circuit reaffirmed its prior holding in Parkcentral Global Hub Ltd. v. Porsche Automobile Holdings SE, 763 F.3d 198 (2d Cir. 2014), that the traditional “irrevocable liability” test is necessary, but not sufficient to bring a claim under the Exchange Act. Instead, a plaintiff must additionally show that the transaction was not “‘so predominantly foreign’ as to be impermissibly extraterritorial.” Cavello Bay, 986 F.3d at 165 (citing Parkcentral, 763 F.3d at 216). The Second Circuit considered that this test “uses Morrison’s focus on the transaction rather than surrounding circumstances, and flexibly considers whether a claim—in view of the security and the transaction as structured—is still predominantly foreign.” Id. at 166–67. Under this framework, the court affirmed the dismissal of an action based on “a private offering between a Bermudan investor . . . and a Bermudan issuer” because it was predominantly foreign, even though the fact that the contract was countersigned in the United States may have been sufficient to incur irrevocable liability in the United States. Id. at 167–68.

On the other hand, in its first application of Morrison, the First Circuit, “[l]ike the Ninth Circuit . . . reject[ed] Parkcentral as inconsistent with Morrison.” Sec. & Exch. Comm’n v. Morrone, 997 F.3d 52, 60 (1st Cir. 2021). Because “Morrison says that § 10(b)’s focus is on transactions,” the court found that “[t]he existence of a domestic transaction suffices to apply the federal securities laws under Morrison” and “[n]o further inquiry is required.” Id.

B. Eighth Circuit Strikes Class Allegations under Rule 12(f)

In Donelson v. Ameriprise Financial Services, Inc., 999 F.3d 1080 (8th Cir. 2021), the Eighth Circuit struck class allegations pursuant to Rule 12(f) of the Federal Rules of Civil Procedure, which permits a court to strike from a pleading “any insufficient defense or any redundant, immaterial, impertinent, or scandalous matter.” Id. at 1091 (quoting Fed. R. Civ. P. 12(f)). The court “agree[d] with the Sixth Circuit that a district court may grant a motion to strike class-action allegations prior to the filing of a motion for class-action certification” when certification is a “clear impossibility,” noting that other federal courts have reached the conclusion that this was not permissible. Id. at 1092.

Donelson concerned an investor’s claims, including under Section 10(b) of the Securities Exchange Act, against a broker and investment advisor for mishandling and making misrepresentations about his investment account. Id. at 1086. The plaintiff sought to bring claims on behalf of a class of individuals who had allegedly suffered similar harms. While the agreement governing the plaintiff’s account contained a mandatory arbitration clause, there was an exception for “putative or certified class actions.” Id. The court found that the class allegations should be stricken because they were not “cohesive” and would require “a significant number of individualized factual and legal determinations to be made,” including specifically whether the defendants made misrepresentations to each investor, whether those misrepresentations were material, whether the investor relied upon them, and whether the investor suffered economic harm. Id. at 1092–93. Furthermore, the court found that the circumstances warranted striking the class allegations because delaying the inevitable decision would “needlessly force the parties to remain in court when they previously agreed to arbitrate.” Id. at 1092.

C. Congress Codifies SEC Disgorgement Remedy

On January 1, 2021, Congress codified the SEC’s right to disgorgement remedies as part of the National Defense Authorization Act (“NDAA”). While the SEC has often sought—and courts have often granted—disgorgement remedies, the new law codifies this right and also adds guidance as to the parameters. Section 6501 of the NDAA amends the Exchange Act to allow any United States District Court to “require disgorgement…of any unjust enrichment by the person who received such unjust enrichment as a result of [violations under the securities laws].” Previously, disgorgement was awarded pursuant to the court’s equitable power, rather than statutorily mandated in cases of unjust enrichment.

Significantly, the amendment also provides for a 10-year statute of limitations that applies to “[any actions for disgorgement arising out] of the securities laws for which scienter must be established.” 15 U.S.C. § 78u(d)(8)(A)(ii). The law further provides for a 10-year statute of limitations for “any equitable remedy, including for an injunction or for a bar, suspension, or cease and desist order” irrespective of whether the underlying securities law violation carries a scienter requirement. 15 U.S.C. § 78u(d)(8)(B). The law expands disgorgement to “any equitable remedy” and ensures that a court awards disgorgement in these cases. Moreover, for the purposes of calculating any limitations period under this paragraph, “any time in which the person . . . is outside of the United States shall not count towards the accrual of that period.” 15 U.S.C. § 78u(d)(8)(C).

D. Delaware Exclusive Forum Bylaws Applicable to Section 14

A recent federal decision in the Northern District of California precluded plaintiffs from bringing Section 14(a) claims in the face of an exclusive forum selection clause in a company’s bylaws. Lee v. Fisher, 2021 WL 1659842 (N.D. Cal. Apr. 27, 2021). In Lee, plaintiffs brought derivative claims on behalf of The Gap, Inc. for violation of Section 14(a) of the Securities Exchange Act as a result of allegedly misleading statements about the Gap’s commitment to diversity. Id. at *1. The defendants moved to dismiss the claims on forum non conveniens grounds based on the forum selection clause in Gap’s bylaws, which provided that any action had to be brought in Delaware Chancery Court. Id. at *2. In granting the motion and dismissing the claims, the court noted a strong policy in favor of enforcing forum selection clauses where practicable. Id. at *3. In response to the plaintiff’s objection that Section 14(a) claims must be asserted in federal court because of its exclusive jurisdiction and that the anti-waiver provisions in the Securities Act preclude waiving the jurisdictional requirement, the court noted Ninth Circuit precedent has held that the policy of enforcing forum selection clauses supersedes anti-waiver provisions like those in the Exchange Act. Id. In addition, enforcement of the exclusive forum selection clause would not leave the plaintiff without a remedy because the plaintiff could file separate state law derivative claims in Delaware, even if such action could not include a federal securities law claim. The plaintiffs have filed a notice of appeal in the Ninth Circuit.

E. Ninth Circuit Upholds Broad Protection for Forward-Looking Statements

In Wochos v. Tesla, Inc., 985 F.3d 1180 (9th Cir. 2021), the Ninth Circuit upheld a broad interpretation of the safe harbor protections afforded by the PSLRA. The PSLRA’s safe harbor for forward-looking statements protects against liability that is premised upon statements made about a company’s plans, objectives, and projections of future performance, along with the assumptions underlying such statements. In Wochos, the Ninth Circuit held that this protection applies even when the statements touch on the current state of affairs.

The plaintiffs in Wochos alleged that statements by Tesla officers that the company was “on track” to meet certain production goals was misleading because the company was facing manufacturing problems that made these production goals difficult to attain. Id. at 1185–86. Plaintiffs claimed that the statements were not protected under the PSLRA’s safe harbor provisions because these “predictive statements contain[ed] embedded assertions concerning present facts that are actionable.” Id. at 1191 (emphasis in original). The court disagreed, finding that the definition of forward-looking statements “expressly includes ‘statement[s] of the plans and objectives of management for future operations,’” and “‘statement[s] of the assumptions underlying or relating to’ those plans and objectives.” Id. (emphases in original). Even though Tesla’s statements touched on the current state of the business, the court found that they were forward-looking because “any announced ‘objective’ for ‘future operations’ necessarily reflects an implicit assertion that the goal is achievable based on current circumstances.” Id. at 1192 (emphasis in original). The court reasoned that the safe harbor would be rendered moot if it “could be defeated simply by showing that a statement has the sort of features that are inherent in any forward-looking statement.” Id. (emphasis in original).

The following Gibson Dunn attorneys assisted in preparing this client update: Jeff Bell, Shireen Barday, Monica Loseman, Brian Lutz, Mark Perry, Avi Weitzman, Lissa Percopo, Michael Celio, Alisha Siqueira, Rachel Jackson, Andrew Bernstein, Megan Murphy, Jonathan D. Fortney, Sam Berman, Fernando Berdion-Del Valle, Andrew V. Kuntz, Colleen Devine, Aaron Chou, Luke Dougherty, Lindsey Young, Katy Baker, Jonathan Haderlein, Marc Aaron Takagaki, and Jeffrey Myers.

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 of the following members of the Securities Litigation practice group:

Monica K. Loseman – Co-Chair, Denver (+1 303-298-5784, mloseman@gibsondunn.com)
Brian M. Lutz – Co-Chair, San Francisco/New York (+1 415-393-8379/+1 212-351-3881, blutz@gibsondunn.com)
Craig Varnen – Co-Chair, Los Angeles (+1 213-229-7922, cvarnen@gibsondunn.com)
Shireen A. Barday – New York (+1 212-351-2621, sbarday@gibsondunn.com)
Jefferson Bell – New York (+1 212-351-2395, jbell@gibsondunn.com)
Matthew L. Biben – New York (+1 212-351-6300, mbiben@gibsondunn.com)
Michael D. Celio – Palo Alto (+1 650-849-5326, mcelio@gibsondunn.com)
Paul J. Collins – Palo Alto (+1 650-849-5309, pcollins@gibsondunn.com)
Jennifer L. Conn – New York (+1 212-351-4086, jconn@gibsondunn.com)
Thad A. Davis – San Francisco (+1 415-393-8251, tadavis@gibsondunn.com)
Ethan Dettmer – San Francisco (+1 415-393-8292, edettmer@gibsondunn.com)
Mark A. Kirsch – New York (+1 212-351-2662, mkirsch@gibsondunn.com)
Jason J. Mendro – Washington, D.C. (+1 202-887-3726, jmendro@gibsondunn.com)
Alex Mircheff – Los Angeles (+1 213-229-7307, amircheff@gibsondunn.com)
Robert F. Serio – New York (+1 212-351-3917, rserio@gibsondunn.com)
Robert C. Walters – Dallas (+1 214-698-3114, rwalters@gibsondunn.com)
Avi Weitzman – New York (+1 212-351-2465, aweitzman@gibsondunn.com)

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

I. Introduction: Themes and Notable Developments

This mid-year update marks the first six months of the Commission under the Biden administration. Change came swiftly, yet is only just beginning. In this update, we look at the significant developments from the first six months of 2021, and consider what to expect from new leadership at the Commission and the Enforcement Division. In sum, it is safe to say that the next four years will see a return to increasing regulatory oversight and escalated enforcement of market participants.

As predicted in our 2020 Year-End Securities Enforcement Update, promptly after President Biden was inaugurated, the White House substituted then Acting Chairman Elad Roisman with the senior Democratic Commissioner, Allison Herren Lee.[1] Under Acting Chair Lee’s leadership, the Commission began a number of initiatives that immediately signaled more aggressive and proactive regulatory oversight, including in areas of climate and environmental, social and governance (ESG) disclosure and investment management, and special purpose acquisition companies (SPACs), both of which are discussed further below. At the same time, Republican Commissioners often issued statements raising concerns about the approach being taken by the Commission in areas such as ESG disclosure and cryptocurrency.[2]

Shortly after her appointment to the Acting Chair position, Acting Chair Lee announced changes to the enforcement process that facilitated the opening of formal investigations and also added uncertainty to the settlement process for companies and SEC registered firms. In February, Acting Chair Lee restored the delegated authority of senior Enforcement Division staff to issue formal orders of investigation, which authorize the staff to issue subpoenas for documents and testimony.[3] The re-delegation of authority reversed the 2017 decision under the Trump administration which restricted authority to issue formal orders to the Director of the Enforcement or the Commissioners. Acting Chair Lee cited the need to allow investigative staff “to act more swiftly to detect and stop ongoing frauds, preserve assets, and protect vulnerable investors.”[4] Immediately following that pronouncement, the Commission announced an end to the practice of permitting settling parties to make contingent settlement offers—offers to resolve an investigation contingent on receiving from the Commission a waiver of collateral consequences, such as disqualifications from regulatory safe harbors, which would otherwise arise from the violations. In her statement, Acting Chair Lee noted that “waivers should not be used as ‘a bargaining chip’ in settlement negotiations, nor should they be considered a ‘default position’ under the SEC.”[5] Following the announcement, Commissioners Hester Peirce and Elad Roisman, both Republicans, issued a joint statement criticizing the impact of the policy reversal on parties seeking to resolve an investigation through a settlement “because it undercuts the certainty and finality that settlement might otherwise provide.”[6]

In April, Gary Gensler was sworn in as Chairman of the SEC.[7] Before joining the SEC, Chairman Gensler was Chairman of the Commodity Futures Trading Commission in the Obama administration and presided over a period of heightened financial regulation and aggressive enforcement against major financial institutions.

In June, Chairman Gensler appointed Gurbir Grewal, the Attorney General for the State of New Jersey, as the new Director of the Division of Enforcement.[8] Mr. Grewal will begin his role as Division Director on July 26. With the appointment of Mr. Grewal, Chairman Gensler continues a trend, begun in the wake of the 2008 financial crisis, of appointing former prosecutors to the that position. Before becoming New Jersey Attorney General, Mr. Grewal had been the Bergen County Prosecutor, and Assistant U.S. Attorney in the District of New Jersey (where he was Chief of the Economic Crimes Unit) and in the Eastern District of New York (where he was assigned to the Business and Securities Fraud Unit). Mr. Grewal also worked in private practice from 1999 to 2004 and 2008 to 2010.

Now that the new Commission leadership is taking shape, we expect the coming months to reflect increasingly the influence of the new administration. Undoubtedly, this will translate into heightened scrutiny on legal and compliance departments and financial reporting functions of financial institutions, investment advisers, broker-dealers, and public companies.

A. Climate and ESG Task Force

In March, Acting Chair Lee announced the creation of a Climate and ESG Task Force.[9] The task force is composed of 22 members drawn from various Commission offices and specialized units. The Climate and ESG task force is charged with developing initiatives to identify ESG-related misconduct and analyzing data to identify potential violations. Additionally, the task force aims to identify misstatements in issuers’ disclosure of climate risks and to analyze disclosure and compliance issues related to ESG stakeholders and investors. The SEC has also established a website and intake submission form for tips, referrals, and whistleblower complaints for ESG-related issues. The task force will work closely with other SEC Divisions and Offices, including the Division of Corporation Finance, Investment Management, and Examinations.

In April, the Division of Examinations issued a Risk Alert detailing its observations of deficiencies and internal control weaknesses from examinations of investment advisers and funds regarding investing that incorporates ESG factors.[10] The Division’s Risk Alert provides a useful roadmap to assist investment advisers in developing, testing and enhancing their compliance policies, procedures and practices. Please see our prior client alert on this subject for an analysis of the lessons learned from the Division’s Risk Alert.

B. Focus on SPACs

Over the course of the first half of this year, the SEC has been intensifying its focus on SPACs. Also referred to as blank check companies, SPACs are shell companies which offer private companies an alternative path to the public securities markets instead of an IPO. A SPAC transaction proceeds in two phases: (i) an initial phase in which the shell company raises investor funds to finance all or a portion of a future acquisition of a private company and (ii) a de-SPAC phase in which the SPAC merges with a private target company. During the de-SPAC phase, investors in the initial SPAC either sell their shares on the secondary market or have their shares redeemed. After the de-SPAC, the entity continues to operate as a public company. Typically, SPACs have two years to complete a merger with a private company.

Earlier this year, senior SEC officials in the Division of Corporation Finance and Office of the Chief Accountant issued a string of pronouncements concerning the risks posed by the explosion of SPAC initial public offerings in 2020 and early 2021, including a potential misalignment of interests and incentives between SPAC sponsors and shareholders.[11] Last week the Commission announced an enforcement action against a SPAC, the SPAC sponsor, and the CEO of the SPAC, as well as the proposed merger target and the former CEO of the target for misstatements in a registration statement and amendments concerning the target’s technology and business risks.[12]

In a separate alert, we analyzed the important implications this enforcement action has for SPACs, their sponsors and executives for their diligence on proposed acquisition targets. To emphasize the point, SEC Chairman Gary Gensler took the unusual step of providing comments that echoed the concerns of senior officials and sent a clear message that even when the SPAC is “lied to” by the target, the SPAC and its executives are at risk for liability under the securities laws if their diligence fails to uncover misrepresentations or omissions by the target. Chairman Gensler stated, “This case illustrates risks inherent to SPAC transactions, as those who stand to earn significant profits from a SPAC merger may conduct inadequate due diligence and mislead investors. . . . The fact that [the target] lied to [the SPAC] does not absolve [the SPAC] of its failure to undertake adequate due diligence to protect shareholders.”

C. Focus on Cybersecurity Risks

For a number of years, the Commission has been increasing its focus on controls and disclosures related to the risks of cyberattacks. In June, the Division of Enforcement publicly disclosed that it was conducting an investigation regarding a cyberattack involving the compromise of software made by the SolarWinds Corp.[13] As part of that investigation, the Division staff issued letters to a number of entities requesting information concerning the SolarWinds compromise. The inquiry is notable both for its public nature as well as the scope of the requests and signals a heightened scrutiny of how companies manage cyber-related risks.

D. Shifting Approach to Penalties against Public Companies

In addition to the overarching expectations for increasingly aggressive enforcement under this administration, the first half of this year also revealed indications that the Commission’s approach to corporate penalties may be undergoing a transition.

For many years the Commission has debated whether, and to what extent, public companies should be subject to monetary penalties in settlement of enforcement actions based on allegations of improper accounting or financial reporting or misleading disclosures. On one hand, advocates for the imposition of substantial penalties argue that they are a statutorily authorized remedy that serves regulatory goals of specific and general deterrence and, since the creation of fair funds, the potential goal of financial remediation. On the other hand, imposing penalties on a public company is simply taking value away from current shareholders of the company, some of whom may also have been the victims of the alleged financial reporting misconduct, and, in the absence of a fair fund, simply transferring that value to the U.S. Treasury. In the wake of the corporate accounting scandals of the 2000s, the SEC’s penalties against public companies rose to the hundreds of millions of dollars, leading to calls for a framework for the determination of appropriate penalties.

In an effort to bring some consistency to the Commission’s and the Enforcement Division’s approach to negotiating corporate penalties, in 2006 the Commission unanimously issued guidance on whether, and to what extent, the Commission should seek to impose penalties against public companies.[14] Rooting the guidance in the legislative history of the 1990 Congressional authorization of SEC penalty authority, the Commission’s 2006 guidance identified two principal factors to determine whether a penalty against a public company would be appropriate: (1) whether the company received a direct financial benefit as a result of the alleged violation, and (2) the extent to which a penalty would recompense or harm injured shareholders. Although the 2006 guidance identified other relevant factors—such as the need for deterrence, egregiousness of the harm from the violation, level of intent, corporate cooperation—the first two factors were of paramount importance. As a general matter, in the years following the 2006 Guidance, the size of corporate penalties in financial reporting cases moderated.

In March of this year, Commissioner Caroline Crenshaw, a Democrat, delivered a speech[15] in which she criticized the 2006 guidance. Calling the guidance “myopic” and “fundamentally flawed,” Commissioner Crenshaw argued that the Commission should not treat the presence or absence of a corporate benefit as a threshold issue to imposing a penalty. Instead, the Commission should focus on factors such as: (1) the egregiousness of the misconduct, (2) the extent of the company’s self-reporting, cooperation and remediation, (3) the extent of harm to victims, (4) the level of complicity of senior management within the company in the alleged misconduct, and (5) the difficulty of detecting the alleged misconduct. Anecdotal experience suggests that a majority of the Commissioners, and consequently, the staff of the Enforcement Division, are following the principles outlined in Commissioner Crenshaw’s speech.

The significance of this for public companies is that the Commission’s approach to corporate penalties diverges from its statutory underpinnings. The securities laws provide for prescribed penalty amounts per violation.[16] In general, in litigated cases, district courts and administrative law judges have generally imposed reasonable limits on the penalties sought by the Commission.[17] If the Commission is no longer following the 2006 guidance, then untethered from a consideration of corporate benefit or shareholder cost-benefit, the Commission’s posture on corporate penalties is vulnerable to subjective assessments of egregiousness and corporate cooperation. Moreover, unlike calculations under the US Sentencing Guidelines, there is no public disclosure of exactly how the SEC reaches a particular penalty, leaving companies and counsel unable to understand the basis for any negotiated penalty amount.

E. Litigation Developments

In the SEC’s ongoing litigation against Ripple Labs, there were notable developments in the defendants’ ability to obtain discovery of the SEC Staff’s prior policy positions concerning whether digital currencies constitute securities. In the pending litigation against Ripple, filed at the end of 2020, the SEC alleges that Ripple’s sales of digital token XRP constituted unregistered securities offerings. In April, a Magistrate Judge hearing discovery disputes granted the defendants’ motion seeking discovery of internal SEC Staff documents bearing on whether XRP tokens are similar to other cryptocurrencies that the SEC Staff has deemed not to be securities. More recently, in July, the Magistrate Judge ordered that the defendants could take the deposition of William Hinman, the former Director of the SEC’s Division of Corporation Finance, regarding a speech he delivered as Division Director concerning whether, in the Staff’s view, certain digital tokens constitute securities. These discovery decisions provide notable precedent for obtaining discovery of evidence relevant to the positions of Commission Staff on policy issues that may be relevant to the issues pending in particular enforcement litigation.

F. Other Senior Staffing Updates

In addition to the confirmation of Chairman Gensler and appointment of Enforcement Director Grewal, there were a number of other changes in the senior staffing of the Commission:

In April, Jane Norberg, Chief of the SEC’s Office of the Whistleblower, left the agency. Ms. Norberg had been with the Office of the Whistleblower since near its inception in 2012. The Office’s Deputy Chief, Emily Pasquinelli, has been serving as Acting Chief pending appointment of a new Chief.
In May, Joel R. Levin, the Director of the Chicago Regional Office, left the SEC.[18] He had served as Director of the Chicago office since 2018. Associate Directors Kathryn A. Pyszka and Daniel Gregus have been serving as Regional Co-Directors pending appointment of a new Regional Director.
In June, Chairman Gensler announced additions to his executive staff, including Amanda Fischer as Senior Counselor; Lisa Helvin as Legal Counsel; Tejal D. Shah as Enforcement Counsel; Angelica Annino as Director of Scheduling and Administration; Liz Bloom as Speechwriter to the Chair; Basmah Nada as Digital Director; and Jahvonta Mason as Special Assistant to the Chief of Staff.
Also in June, Renee Jones joined the SEC as Director of the Division of Corporation Finance, while the Acting Director of the Division, John Coates, was named SEC General Counsel.[19] Jones previously served as Professor of Law and Associate Dean for Academic Affairs at Boston College Law School, is a member of the American Law Institute and has served as the Co-Chair of the Securities Law Committee of the Boston Bar Association. Mr. Coates had previously served as the SEC’s Acting Director of the Division of Corporate Finance since February 2021. Before joining the SEC, he was Professor of Law and Economics at Harvard University.

G. Whistleblower Awards

Coming off another record year of whistleblower awards in 2020, the Commission has continued to issue awards at a record pace in the first half of 2021. There is no reason to believe that these awards will slow down given the importance of the program to the Commission. Through June of this year, the SEC’s whistleblower program has awarded nearly $200 million to 45 separate whistleblowers. That is almost $100 million more than the first half of 2020, which was $115 million to 15 individuals. Overall, the SEC’s whistleblower program has paid out approximately $937 million to 178 individuals since the start of the program.

In April, the SEC announced an award of over $50 million to joint whistleblowers for information that alerted the SEC to violations involving highly complex transactions that would have “been difficult to detect without their information.”[20] This award is the second largest in the history of the program and reflects the Commission’s dedication to recovering funds for harmed investors.

Other significant whistleblower awards granted during the first half of this year include:

Four awards in January, including an award of almost $500,000 to three whistleblowers in connection with two related enforcement actions; nearly $600,000 to a whistleblower whose information caused the opening of an investigation, and for the whistleblower’s ongoing assistance in the SEC’s investigation; an award of more than $100,000 to a whistleblower whose independent analysis led to a successful enforcement action;[21] and an award of $600,000 to a whistleblower whose tip led to the success of an enforcement action.[22]
Five awards in February, including a $9.2 million award to a whistleblower who provided information that led to successful related actions by the Department of Justice.[23] Additional awards in February included two awards totaling almost $3 million to two separate whistleblowers whose high quality information led to an enforcement action that resulted in millions of dollars to harmed clients;[24] and two awards totaling more than $1.7 million to two whistleblowers in separate proceedings relating to the new Form TCR filing requirement set forth in Securities Exchange Act Rule 21F-9(e).[25]
Four awards in March, including over $500,000 to two whistleblowers for tips that revealed ongoing fraud;[26] an award of over $5 million to joint whistleblowers whose tip resulted in the opening of an investigation;[27] approximately $1.5 million to a whistleblower whose information and assistance led to a successful SEC enforcement action;[28] and an award of more than $500,000 to a whistleblower for information and assistance that led to the shutting down of an ongoing fraudulent scheme.[29]
Three awards in April, including an award of approximately $2.5 million to a whistleblower whose information and assistance to the SEC contributed to the success of an SEC enforcement action;[30] a $3.2 million award to a whistleblower who alerted the SEC to violations and provided subject matter expertise to the staff that conserved SEC resources; and a $100,000 award to a whistleblower for significant information and ongoing assistance.[31]
Six awards in May, including two awards totaling $31 million to four whistleblowers, two of which received $27 million for providing the SEC with new information and assistance during an existing investigation; and two others who received $3.76 million and $750,000 respectively for independently providing the SEC with information that assisted an ongoing investigation.[32] Additional awards in May include an award of approximately $22 million to two whistleblowers for information and assistance that was “crucial” to a successful enforcement action brought against a financial services firm;[33] a $3.6 million award to a whistleblower whose information and assistance led to a successful enforcement action;[34] an award of more than $28 million to a whistleblower for information that caused both the SEC and another agency to open investigations that resulted in significant enforcement actions;[35] and an award of more than $4 million to a whistleblower who alerted the SEC to certain violations that led to the opening of an investigation.[36]
Five awards in June, including an award of more than $23 million to two whistleblowers whose information and assistance led to successful SEC and related actions;[37] an award of $3 million to two whistleblowers who separately and independently provided the SEC with valuable information and ongoing assistance;[38] two awards totaling nearly $5.3 million to four whistleblowers who provided information that prompted the opening of two separate investigations;[39] and an award of more than $1 million to a whistleblower whose information and assistance led to multiple successful SEC enforcement actions.[40]

II. Public Company Accounting, Financial Reporting and Disclosure Cases

A. Financial Reporting Cases

Cases Against Public Companies and Executives

In February, the SEC announced settled charges against the former CEO and CFO of a company that provides Flexible Spending Account services for allegedly making false and misleading statements and omissions that resulted in the company’s improper recognition of revenue related to a contract with a large public-sector client.[41] The SEC’s order alleged that one of the company’s large public sector clients stated on multiple occasions that it did not intend to pay for certain development and transition work associated with an existing contract. The CEO and CFO allegedly directed the company to recognize $3.6 million in revenue related to this work without disclosing to internal accounting staff or to the company’s external auditor that the client’s employees denied that it owed these amounts to the company. Without admitting or denying the SEC’s findings, the CEO and CFO agreed respectively to cease and desist from further violations of the charged provisions, pay penalties of $75,000 and $100,000, and reimburse the company for incentive-based compensation received on the basis of the alleged violations.

In May, the SEC instituted a settled action against a sports apparel manufacturer for allegedly misleading investors as to the bases of its revenue growth and failing to disclose known uncertainties concerning its future revenue prospects.[42] The SEC’s order alleged that the company accelerated, or “pulled forward,” a total of $408 million in existing orders that customers had requested be shipped in future quarters and that the company attributed its revenue growth during the relevant period to a variety of other factors without disclosing to investors material information about the impact of its pull forward practices. The company agreed to cease and desist from further violations and to pay a $9 million penalty without admitting or denying the findings in the SEC order.

Cases Against Auditors and Accountants

In February, the SEC suspended two former auditors from practicing before the SEC in connection with settled charges alleging improper professional conduct during an audit of a now defunct, not-for-profit educational institution.[43] The auditors allegedly issued an audit report without following Generally Accepted Auditing Standards by, among other things, failing to obtain sufficient appropriate audit evidence or to properly prepare audit documentation. The resultant financial statements allegedly fraudulently overstated the college’s net assets by $33.8 million. Without admitting or denying the findings, the auditors agreed to the suspension with the right to apply for reinstatement after three years and one year, respectively.

In April, the SEC instituted administrative proceedings against a Texas-based CPA for allegedly failing to register his firm with the Public Company Accounting Oversight Board (PCAOB) and alleged failures in auditing and reviewing the financial statements of a public company client.[44] The CPA allegedly failed to complete his application to register with the PCAOB and performed an audit while the application was incomplete. The audit allegedly failed to comply with multiple PCAOB Auditing Standards as well. The proceedings will be scheduled for a public hearing before the Commission.

B. Disclosure Cases

In February, the SEC announced settled charges against a gas exploration and production company and its former CEO for failing to properly disclose as compensation certain perks provided to the CEO and certain related personal transactions.[45] The alleged failures to disclose included approximately $650,000 in the form of perquisites, including costs associated with the CEO’s use of the company’s chartered aircraft and corporate credit card. The SEC took into account the company’s significant cooperation efforts when accepting the settlement offer. The Company and CEO agreed, without admitting or denying to the SEC’s findings, to cease-and-desist from further violations. Additionally, the CEO agreed to pay a civil penalty in the amount of $88,248.

In April, the SEC instituted a settled action against eight companies for allegedly failing to disclose in SEC Form 12b-25 “Notification of Late Filing” forms (known as Form NT) that their requests for seeking a delayed quarterly or annual reporting filing was caused by an anticipated restatement or correction of prior financial reporting.[46] The orders found that each company announced restatements or corrections to financial reporting within four to fourteen days of their Form NT filings despite failing to disclose that anticipated restatements or corrections were among the principal reasons for their late filings. The companies, without admitting or denying the findings, agreed to cease-and-desist-orders and paid penalties of either $25,000 or $50,000.

In May, the SEC announced settled charges against a firm that produces, maintains, licenses, and markets stock market indices.[47] The SEC’s order alleged failures relating to a previously undisclosed quality control feature of one of the firm’s volatility-related indices, which allegedly led it to publish and disseminate stale index values during a period of unprecedented volatility. The allegedly undisclosed feature was an “Auto Hold”, which is triggered if an index value breaches certain thresholds, at which point the immediately prior index value continues to be reported. Without admitting or denying the SEC’s findings, the firm agreed to a cease-and-desist order and to pay a $9 million penalty.

C. Disclosure and Internal Controls Case against Ratings Agency

In February, the SEC filed a civil action against a former credit ratings agency. The SEC’s complaint alleged that the agency violated disclosure and internal control provisions in rating commercial mortgage-backed securities (CMBS).[48] According to the complaint, the credit ratings agency allowed analysts to make undisclosed adjustments to ratings models and did not establish and enforce effective internal controls over these adjustments for 31 transactions.

III. Investment Advisers and Broker-Dealers

A. Investment Advisers

In late May, the SEC filed a civil action against two investment advisers and their portfolio managers for allegedly misleading investors about risk management practices related to their short volatility trading strategy.[49] According to the SEC’s complaint, the investment advisers made misleading statements about their risk management practices. During a period of historically low volatility in late 2017, the investment adviser firms increased the level of risk in the portfolios while assuring investors that the portfolios’ risk profiles remained stable. The SEC’s complaint alleged that a sudden spike in volatility in early 2018 led to trading losses exceeding $1 billion over two trading days. The SEC separately settled related charges with the Firm’s Chief Risk Oficer.

In mid-June, the SEC announced that it had obtained an asset freeze and filed charges against a Miami-based investment professional and two investment firms for engaging in a “cherry-picking” scheme in which they allegedly channeled trading profits to preferred accounts.[50] The SEC alleged that beginning in September 2015, the firms diverted profitable trades to accounts held by relatives and allocated losing trades to other clients by using a single account to place trades without specifying the intended recipients of the securities at the time of the trade. According to the SEC’s complaint, the preferred clients received approximately $4.6 million in profitable trades while the other clients experienced over $5 million in first-day losses.

B. Broker-Dealer Reporting and Recordkeeping

In May, the SEC announced settled charges against a Colorado-based broker-dealer for failing to file Suspicious Activity Reports (SARs).[51] The purpose of SARs is to identify and investigate potentially suspicious activity. The SEC’s order alleged that for a three-year period, the broker-dealer failed to file SARs—or filed incomplete SARs—while it was aware that there were attempts to use improperly obtained personal identifying information to gain access to the retirement accounts of individual plan participants at the broker-dealer. The SEC’s order noted significant cooperation by the broker-dealer and remedial efforts including anti-money laundering systems, replacing key personnel, clarifying delegation of responsibility, and implement new SAR-related policies and training.

IV. Cryptocurrency and Digital Assets

A. Registration Case

In May, the SEC filed a civil action against five individuals for allegedly promoting unregistered digital asset securities.[52] The defendants worked as promoters for an open-source cryptocurrency, raising over $2 billion dollars from retail investors. The SEC’s complaint alleged that from January 2017 to January 2018, the promoters advertised the cryptocurrency’s “lending program” by creating “testimonial” style videos that appeared on YouTube. According to the complaint, the defendants did not register as broker-dealers and also did not register the securities offering. The complaint seeks injunctive relief, disgorgement, and civil penalties from all five defendants.

B. Fraud Case

In February, the SEC filed a civil action against three defendants, a founder of two digital currency companies and promoters for the companies, for allegedly defrauding hundreds of retail investors out of over $11 million through digital asset securities offerings.[53] The SEC’s complaint alleged that from December 2017 to January 2018, the individuals induced investors to purchase securities in the companies by claiming their trading platform was the “largest” and “most secure” Bitcoin exchange. The defendants then promoted the unregistered initial coin offering of their cryptocurrency, referred to as B2G tokens by telling investors that their cryptocurrency would be built on the Ethereum blockchain and would launch in April 2018. Instead, the SEC claims, the defendants misappropriated the investor funds for their personal benefit. The complaint seeks injunctive relief, disgorgement, and penalties, along with an officer and director bar for the founder and one promoter. The U.S. Attorney’s Office for the Eastern District of New York and the Department of Justice Fraud Section announced parallel criminal charges against the promoter.

V. Meme Stocks

In the first half of this year, the SEC responded to the growing presence of ‘meme stocks,’ which undergo spikes of rapid growth in short periods of time largely in response to social media activity. In January, following a period of increased market activity in GameStop stock fueled by posts on the social media aggregator site Reddit, the SEC released an alert that warned investors against “jump[ing] on the bandwagon” and emphasized avoiding making investment decisions based on social media posts.[54]

A. Trading Suspensions

In February, the SEC suspended trading in an inactive company due to potentially manipulative social media activity attempting to artificially inflate the company’s stock price.[55] The SEC’s trading suspension order stated that in January 2021, several social media accounts coordinated to increase the share price of stocks for a Minnesota-based medical device company, although the company had not filed reports with the SEC since 2017 and its website and contact information were non-functional. During this time, the share price and trading volume of the company’s securities increased. A few weeks later, the SEC suspended trading in the securities for 15 companies again in response to social media activity relating to the issuers, none of which had filed information with the SEC for over a year.[56] In total, the SEC suspended trading for 24 companies in February because of suspicious social media posts.

B. Fraud Case

In March, the SEC announced a filed civil action and an asset freeze against a California-based trader for allegedly using social media to post false information about a company, while selling his own holdings in the company’s stock.[57] The SEC’s complaint alleged that the defendant purchased 41 million shares of stock from a defunct company with publicly traded securities. In the same day, the trader allegedly made over 120 tweets containing false information about the company, including that the company recently revived its operations and expanded its business. As an example, one of the posts alleged that the company had “huge” investors and the CEO had “big plans” for the company’s future. In the following days, the company’s share price increased by over 4,000 percent, at which point the defendant sold his shares for a profit of over $929,000 dollars and continued to post on Twitter about the company’s success. The complaint seeks a permanent injunction, disgorgement, and a civil penalty. The SEC also temporarily suspended trading in the company’s securities.[58]

VI. Insider Trading

In March, the SEC filed settled charges against a California individual for perpetuating a scheme to sell “insider tips” on the dark web.[59] This is the SEC’s first enforcement action involving alleged securities violations on the dark web, a platform allowing users to access the internet anonymously. The complaint alleged that the individual falsely claimed to possess material, nonpublic information, which he sold on the dark web. Several investors purchased the individual’s purported tips and traded on the information he provided. The individual agreed to a bifurcated settlement (which reserves the determination of disgorgement and penalties for a later date); the U.S. Attorney’s Office for the Middle District of Florida announced parallel criminal charges.

In June 2021, the SEC announced settled charges against a New York-based couple for insider trading relating to the stock of a pharmaceutical company where one of them worked as a clinical trial project manager.[60] According to the SEC’s complaint, the project manager learned of negative results from the drug trial she oversaw, and tipped another individual who sold all of his stock in the pharmaceutical company ahead of the public news announcement. The individual also tipped his uncle, who also sold all of his stock. After the negative news was announced, the company stock fell approximately 50%, which would have led to losses of over $100,000 for the individuals had the individuals not sold their stock. The individuals have agreed to pay around $325,000 to settle the charges.

VII. Regulation FD

In the twenty years since the adoption of Regulation FD, which prohibits selective disclosure by public companies of material, non-public material information, the Commission has filed only two litigated enforcement actions alleging violation of the Rule. The first case, filed against Seibel Systems in 2005, ended swiftly when the district court granted the defendants’ motion to dismiss the Commission’s complaint for failure to state a claim.[61] More than fifteen years later, in March of this year, the SEC filed a litigated action against AT&T and three investor relations employees.[62] The complaint alleges that the three IR employees selectively released material financial data in March and April of 2016. Specifically, the SEC alleges that the IR employees disclosed material nonpublic information to a group of analysts at twenty research firms in an effort to avoid the Company’s quarterly revenue falling short of the analyst community’s estimates. AT&T issued a statement in response explaining that any information discussed in communications with analysts was public and immaterial.[63] Among other things, AT&T noted that the information discussed with analysts “concerned the widely reported, industry-wide phase-out of subsidy programs for new smartphone purchases and the impact of this trend on smartphone upgrade rates and equipment revenue…. Not only did AT&T publicly disclose this trend on multiple occasions before the analyst calls in question, but AT&T also made clear that the declining phone sales had no material impact on its earnings.” Notably, AT&T highlighted the fact that the Commission’s complaint “does not cite a single witness involved in any of these analyst calls who believes that material nonpublic information was conveyed to them.”

VIII. Offering Frauds

The SEC continued to bring a large number of offering fraud cases in the first half of 2021.

A. Investment Frauds

In January, the SEC filed two civil actions; the first was against a real estate broker and his company for raising $58 million from investors in two real estate funds by using a fabricated investment record.[64] The SEC’s complaint also alleged that the broker, who had no investment management experience, misappropriated over $7 million in investor assets to conceal losses that ultimately forced the funds to wind down. In the second action, the SEC filed a complaint against an entertainment company and its founder for using a “boiler room” sales scheme to raise money from investors.[65] According to the complaint, the company employed salespeople who utilized high-pressure tactics and made misrepresentations about the company’s growth in order to raise $14 million from individual investors. Both complaints seek disgorgement, injunctive relief, and civil penalties.

In early March, the SEC filed charges against seven individuals and a technology company for an alleged scheme to raise the price of the company’s stock, after which they sold their shares for proceeds of over $22 million.[66] The complaint also alleged that during this campaign, approximately $22.8 million was raised from investors who were allegedly misled about the true nature of the company and that a large portion of the money raised from investors was used for personal expenses. The complaint seeks disgorgement, civil penalties, and injunctive relief.

In mid-March, the SEC announced three cases relating to investor frauds. The SEC filed a civil complaint against a New Jersey resident for defrauding potential investors, most of whom were members of the Orthodox Jewish community, including friends and family of the defendant.[67] According to the complaint, the defendant raised millions of dollars using misleading and false representations regarding his real estate investment company, which purchased and owned apartment complexes. The individual defendant agreed to settle the charges against him subject to court approval; the U.S. Attorney’s Office for the District of New Jersey filed parallel criminal charges. The SEC also filed a civil complaint against an individual who raised money from investors in his company by making representations that was an environmentally friendly drink bottling and manufacturing company.[68] The complaint alleged that in reality, the company had no operations, and the money was used by the defendant for personal expenses. The SEC obtained emergency relief in this matter and the seeks complaint injunctive relief and civil penalties. Finally, the SEC filed charges against the two co-founders of a San Francisco-based biotech company for raising funds from investors by misrepresenting their company as a fast-growing medical company that could improve people’s lives via new inventions in the “microbiome industry.”[69] The complaint alleged that the co-founders’ claims regarding their clinical testing were based on false medical tests and other improper practices. The U.S. Attorney’s Office for the Northern District of California filed parallel criminal charges against the co-founders.

In April, the SEC filed a pair of civil actions against firms and their executives for conduct which resulted in significant investor losses. In the first action, the SEC alleged that an Israeli-based company and two of its former executives created a binary option securities trading platform in which investor losses were probable, and failed to inform investors that their partners were counterparties on the options.[70] In the second action, the SEC alleged that an individual and investment adviser misled investors regarding the strategy for his fund, and induced them to invest in highly illiquid companies and real estate rather than liquid assets as promised.[71] The complaint further alleged that the individual misappropriated fund assets for personal uses and failed to disclose all conflicts of interest. The U.S. Attorney’s Office for the Southern District of New York filed parallel criminal charges against the individual.

In May, the SEC filed charges against a New Jersey-based healthcare company and its founder for fraudulently raising money from investors by selling them membership interests in a company that purportedly offered employers a supplemental medical reimbursement plan.[72] The complaint alleged that the individual defendant raised money from investors through various misrepresentations, including failing to disclose his prior felony convictions and history of regulatory violations. The complaint seeks disgorgement, injunctive relief, and civil penalties.

B. Ponzi-Like Schemes

In February, the SEC filed a civil action against three individuals and their affiliated entities alleging that they conducted a Ponzi-like scheme that raised more than $1.7 billion.[73] The complaint alleged that the defendants promised investors an 8% annualized distribution payment, and represented that it was generated by portfolio companies when it was in fact sourced from other investor money. The complaint seeks disgorgement and civil penalties.

In March, the SEC filed a settled complaint against an individual for operating a decade-long fraud in which he transferred poorly performing assets from a fund controlled by him to two private hedge funds.[74] The defendant told investors that these funds were generating positive returns when a substantial number of the investments were actually used to make Ponzi-like payments to prior investors. The defendant agreed to settle to these charges, and also pled guilty to related criminal charges in the District of New Jersey.

In April, the SEC filed two civil actions alleging Ponzi-like schemes. In the first action, the SEC alleged that an actor raised $690 million by promising investors high returns by telling them that they were buying film rights which he would resell to HBO and Netflix.[75] The defendant allegedly paid investors the returns using new investments, and also misappropriated investor funds for his personal use. In the second action, the SEC’s complaint alleged that the defendant raised more than $17.1 million from over 100 investors by promising investors annual returns between 10% and 60% on resale of “customer lead generation campaigns.”[76] According to the complaint, the defendant instead use the investments to make payments to other investors and entities, as well as for personal expenses.

____________________________

[1] SEC Press Release, Allison Herren Lee Named Acting Chair of the SEC (January 21, 2021), available at https://www.sec.gov/news/press-release/2021-13.

[2] https://www.sec.gov/news/public-statement/peirce-roisman-coinschedule; https://www.sec.gov/news/public-statement/rethinking-global-esg-metrics.

[3] SEC Press Release, U.S. Sec. & Exch. Comm’n, Statement of Acting Chair Allison Herren Lee on Empowering Enforcement to Better Protect Investors (Feb, 9, 2021), https://www.sec.gov/news/public-statement/lee-statement-empowering-enforcement-better-protect-investors.

[4] Id.

[5] See Allison Herren Lee, Acting Chair, Statement of Acting Chair Allison Herren Lee on Contingent Settlement Offers (Feb. 11, 2021), https://www.sec.gov/news/public-statement/lee-statement-contingent-settlement-offers-021121.

[6] See Hester M. Peirce & Elad L. Roisman, Commissioners, Statement of Commissioners Hester M. Peirce and Elad L. Roisman on Contingent Settlement Offers (Feb. 12, 2021), https://www.sec.gov/news/public-statement/peirce-roisman-statement-contingent-settlement-offers-021221.

[7] SEC Press Release, Gary Gensler Sworn in as Member of the SEC (April 17, 2021), available at https://www.sec.gov/news/press-release/2021-65.

[8] SEC Appoints New Jersey Attorney General Gurbir S. Grewal as Director of Enforcement, Rel. No. 2021-114, June 29, 2021, available at https://www.sec.gov/news/press-release/2021-114.

[9] SEC Press Release, SEC Announces Enforcement Task Force Focused on Climate and ESG Issues (March 4, 2021), https://www.sec.gov/news/press-release/2021-42.

[10] The Division of Examinations’ Review of ESG Investing, April 9, 2021, available at https://www.sec.gov/files/esg-risk-alert.pdf.

[11] March 31, 2021 Staff Statement on Select Issues Pertaining to Special Purpose Acquisition Companies, available at https://www.sec.gov/news/public-statement/division-cf-spac-2021-03-31; March 31, 2021 Public Statement: Financial Reporting and Auditing Considerations of Companies Merging with SPACs, available at https://www.sec.gov/news/public-statement/munter-spac-20200331; Apr. 8, 2021 Public Statement: SPACs, IPOs and Liability Risk under the Securities Laws, available at https://www.sec.gov/news/public-statement/spacs-ipos-liability-risk-under-securities-laws; Apr. 12, 2021 Public Statement: Staff Statement on Accounting and Reporting Considerations for Warrants Issued by Special Purpose Acquisition Companies (“SPACs”), available at https://www.sec.gov/news/public-statement/accounting-reporting-warrants-issued-spacs; SEC Official Warns on Growth of Blank-Check Firms, Wall St. Journal (Apr. 7, 2021), available at https://www.wsj.com/articles/sec-official-warns-on-growth-of-blank-check-firms-11617804892.

[12] Press Release, Securities and Exchange Commission, SEC Charges SPAC, Sponsor Merger Target, and CEOs for Misleading Disclosures Ahead of Proposed Business Combination (July 13, 2021), available at https://www.sec.gov/news/press-release/2021-124.

[13] In the Matter of Certain Cybersecurity-Related Events (HO-14225) FAQs, available at https://www.sec.gov/enforce/certain-cybersecurity-related-events-faqs.

[14] Statement of the Securities and Exchange Commission Concerning Financial Penalties, Rel. 2006-4, Jan. 4, 2006, available at https://www.sec.gov/news/press/2006-4.htm.

[15] Moving Forward Together – Enforcement for Everyone, Commissioner Caroline A. Crenshaw, March 9, 2021, available at https://www.sec.gov/news/speech/crenshaw-moving-forward-together.

[16] See, e.g., Securities Exchange Act of 1934, Section 21(d)(3) (15 U.S.C. § 78u).

[17] See, e.g., In re Total Wealth Management, Inc., Initial Dec. No. 860 (Aug. 17, 2005) (finding Enforcement Division staff’s argument that each investor constitutes a separate violation “arbitrary” and “overly simplistic” and may “lead to wildly disproportionate penalty amounts.”).

[18] SEC Press Release, Joel R. Levin, Director of Chicago Regional Office, to Leave SEC, (April 16, 2021), available at https://www.sec.gov/news/press-release/2021-63.

[19] SEC Press Release, Renee Jones to Join SEC as Director of Corporation Finance; John Coates Named SEC General Counsel, (June 14, 2021), available at https://www.sec.gov/news/press-release/2021-101.

[20] SEC Press Release, SEC Awards Over $50 Million to Joint Whistleblowers (April 15, 2021), available at https://www.sec.gov/news/press-release/2021-62.

[21] SEC Press Release, SEC Issues Over $1.1 Million to Multiple Whistleblowers (January 7, 2021), available at https://www.sec.gov/news/press-release/2021-2.

[22] SEC Press Release, SEC Awards Nearly $600,000 to Whistleblower (January 14, 2021), available at https://www.sec.gov/news/press-release/2021-7.

[23] SEC Press Release, SEC Awards Almost $3 Million Total in Separate Whistleblower Awards (February 19, 2021), available at https://www.sec.gov/news/press-release/2021-31.

[24] SEC Press Release, SEC Awards More Than $9.2 Million to Whistleblower for Successful Related Actions, Including Agreement with DOJ (February 23, 2021), available at https://www.sec.gov/news/press-release/2021-30.

[25] SEC Press Release, SEC Issues Whistleblower Awards Totaling Over $1.7 Million (February 25, 2021), available at https://www.sec.gov/news/press-release/2021-34.

[26] SEC Press Release, SEC Awards Over $500,000 to Two Whistleblowers (March 1, 2021), available at https://www.sec.gov/news/press-release/2021-37.

[27] SEC Press Release, SEC Issues Over $5 Million to Joint Whistleblowers Located Abroad (March 4, 2021), available at https://www.sec.gov/news/press-release/2021-41.

[28] SEC Press Release, SEC Awards Approximately $1.5 Million to Whistleblower (March 9, 2021), available at https://www.sec.gov/news/press-release/2021-44.

[29] SEC Press Release, SEC Awards Over $500,000 to Whistleblower Under “Safe Harbor” for Internal Reporting and Surpasses Record for Individual Awards (March 29, 2021), available at https://www.sec.gov/news/press-release/2021-54.

[30] SEC Press Release, SEC Awards Approximately $2.5 Million to Whistleblower (April 9, 2021), available at https://www.sec.gov/news/press-release/2021-60.

[31] SEC Press Release, SEC Awards More Than $3 Million to Whistleblowers in Two Enforcement Actions (April 23, 2021), available at https://www.sec.gov/news/press-release/2021-70.

[32] SEC Press Release, SEC Awards More Than $31 Million to Whistleblowers in Two Enforcement Actions (May 17, 2021), available at https://www.sec.gov/news/press-release/2021-85.

[33] SEC Press Release, SEC Awards $22 Million to Two Whistleblowers (May 10, 2021), available at https://www.sec.gov/news/press-release/2021-81.

[34] SEC Press Release, SEC Awards Approximately $3.6 Million to Whistleblower (May 12, 2021), available at https://www.sec.gov/news/press-release/2021-83.

[35] SEC Press Release, SEC Awards More Than $28 Million to Whistleblower Who Aided SEC and Other Agency Actions (May 19, 2021), available at https://www.sec.gov/news/press-release/2021-86.

[36] SEC Press Release, SEC Awards More Than $4 Million to Whistleblower (May 27, 2021), available at https://www.sec.gov/news/press-release/2021-88.

[37] SEC Press Release, SEC Awards More Than $23 Million to Whistleblowers (June 2, 2021), available at https://www.sec.gov/news/press-release/2021-91.

[38] SEC Press Release, SEC Awards Approximately $3 Million to Two Whistleblowers (June 14, 2021), available at https://www.sec.gov/news/press-release/2021-100.

[39] SEC Press Release, SEC Issues Whistleblower Awards Totaling Nearly $5.3 Million (June 21, 2021), available at https://www.sec.gov/news/press-release/2021-106.

[40] SEC Press Release, SEC Awards More Than $1 Million to Whistleblower (June 24, 2021), available at https://www.sec.gov/news/press-release/2021-110.

[41] SEC Press Release, SEC Charges Former Executives of San Francisco Bay Area Company With Accounting Violations (Feb. 2, 2021), available at https://www.sec.gov/news/press-release/2021-23.

[42] SEC Press Release, SEC Charges Under Armour Inc. With Disclosure Failures (May 3, 2021), available at https://www.sec.gov/news/press-release/2021-78.

[43] SEC Press Release, SEC Charges Two Former KPMG Auditors for Improper Professional Conduct During Audit of Not-for-Profit College (Feb. 23, 2021), available at https://www.sec.gov/news/press-release/2021-32.

[44] SEC Press Release, Auditor Charged for Failure to Register with PCAOB and Multiple Audit Failures (Apr. 5, 2021), available at https://www.sec.gov/news/press-release/2021-56.

[45] SEC Press Release, SEC Charges Gas Exploration and Production Company and Former CEO with Failing to Disclose Executive Perks (Feb. 24, 2021), available at https://www.sec.gov/news/press-release/2021-33.

[46] SEC Press Release, SEC Charges Eight Companies for Failure to Disclose Complete Information on Form NT (Apr. 29 2021), available at https://www.sec.gov/news/press-release/2021-76.

[47] SEC Press Release, SEC Charges S&P Dow Jones Indices for Failures Relating to Volatility-Related Index (May 17, 2021), available at https://www.sec.gov/news/press-release/2021-84.

[48] SEC Press Release, SEC Charges Ratings Agency With Disclosure And Internal Controls Failures Relating To Undisclosed Model Adjustments (February 16, 2021), available at https://www.sec.gov/news/press-release/2021-29.

[49] SEC Press Release, SEC Charges Mutual Fund Executives with Misleading Investors Regarding Investment Risks in Funds that Suffered $1 Billion Trading Loss (May 27, 2021), available at https://www.sec.gov/news/press-release/2021-89.

[50] SEC Press Release, SEC Charges Investment Advisers With Cherry-Picking, Obtains Asset Freeze (June 17, 2021), available at https://www.sec.gov/news/press-release/2021-105.

[51] SEC Press Release, SEC Charges Broker-Dealer for Failures Related to Filing Suspicious Activity Reports (May 12, 2021), available at https://www.sec.gov/news/press-release/2021-82.

[52] SEC Press Release, SEC Charges U.S. Promoters of $2 Billion Global Crypto Lending Securities Offering (May 28, 2021), available at https://www.sec.gov/news/press-release/2021-90.

[53] SEC Press Release, SEC Charges Three Individuals in Digital Asset Frauds (Feb. 1, 2021), available at https://www.sec.gov/news/press-release/2021-22.

[54] SEC Investor Alert, Thinking About Investing in the Latest Hot Stock? (Jan. 30, 2021), available at https://www.sec.gov/oiea/investor-alerts-and-bulletins/risks-short-term-trading-based-social-media-investor-alert.

[55] SEC Press Release, SEC Suspends Trading in Inactive Issuer Touted on Social Media (Feb. 11, 2021), available at https://www.sec.gov/news/press-release/2021-28.

[56] SEC Order of Suspension of Trading, In the Matter of Bebiba Beverage Co., et. al. (Feb. 25, 2021), available at https://www.sec.gov/litigation/suspensions/2021/34-91213-o.pdf.

[57] SEC Press Release, SEC Obtains Emergency Asset Freeze, Charges California Trader with Posting False Stock Tweets (Mar. 15, 2021), available at https://www.sec.gov/news/press-release/2021-46.

[58] SEC Order of Suspension of Trading, In the Matter of Arcis Resources Corporation (Mar. 2, 2021), available at https://www.sec.gov/litigation/suspensions/2021/34-91245-o.pdf.

[59] SEC Press Release, SEC Charges California-Based Fraudster With Selling “Insider Tips” on the Dark Web (March 18, 2021), available at https://www.sec.gov/news/press-release/2021-51.

[60] SEC Press Release, SEC Charges Couple With Insider Trading on Confidential Clinical Trial Data (June 7, 2021), available at https://www.sec.gov/news/press-release/2021-94.

[61] SEC v. Siebel Systems, Inc., 384 F. Supp. 2d 694 (S.D.N.Y. 2005).

[62] SEC Press Release, SEC Charges AT&T and Three Executives with Selectively Providing Information to Wall Street Analysts (Mar. 5, 2021), available at https://www.sec.gov/news/press-release/2021-43.

[63] AT&T Disputes SEC Allegations, Mar. 5, 2021, available at https://www.prnewswire.com/news-releases/att-disputes-sec-allegations-301241737.html.

[64] SEC Press Release, SEC Charges Real Estate Fund Manager With Misappropriating Over $7 Million From Retail Investors (Jan. 12, 2021), available at https://www.sec.gov/news/press-release/2021-4.

[65] SEC Press Release, SEC Charges Vuuzle Media Corp. and Affiliated Individuals in Connection With $14 Million Offering Fraud (Jan. 27, 2021), available at https://www.sec.gov/news/press-release/2021-18.

[66] SEC Press Release, SEC Charges Seven Individuals for $45 Million Fraudulent Scheme (Mar. 2, 2021), available at https://www.sec.gov/news/press-release/2021-38.

[67] SEC Press Release, SEC Charges Owner of Real Estate Investment Company with Defrauding Investors (Mar. 18, 2021), available at https://www.sec.gov/news/press-release/2021-48.

[68] SEC Press Release, SEC Obtains Emergency Asset Freeze, Charges Colorado Resident with Fraud Involving Sham Bottling Company (Mar. 18, 2021), available at https://www.sec.gov/news/press-release/2021-50.

[69] SEC Press Release, SEC Charges Co-Founders of San Francisco Biotech Company With $60 Million Fraud (Mar. 18, 2021), available at https://www.sec.gov/news/press-release/2021-49.

[70] SEC Press Release, SEC Charges Binary Options Trading Platform and Two Top Executives with Fraud (Apr. 19, 2021), available at https://www.sec.gov/news/press-release/2021-66.

[71] SEC Press Release, SEC Charges Fund Manager and Former Race Car Team Owner with Multimillion Dollar Fraud (Apr. 23, 2021), available at https://www.sec.gov/news/press-release/2021-71-0.

[72] SEC Press Release, SEC Charges Healthcare Company and Its Founder with Multimillion Dollar Fraud (May 19, 2021), available at https://www.sec.gov/news/press-release/2021-87.

[73] SEC Press Release, SEC Charges Investment Adviser and Others With Defrauding Over 17,000 Retail Investors (Feb. 4, 2021), available at https://www.sec.gov/news/press-release/2021-24.

[74] SEC Press Release, SEC Charges Unregistered Investment Adviser with Defrauding Investors in Decade-Long Scheme (Mar. 9, 2021), available at https://www.sec.gov/news/press-release/2021-45.

[75] SEC Press Release, SEC Obtains Emergency Asset Freeze, Charges Actor with Operating a $690 Million Ponzi Scheme (Apr. 6, 2021), available at https://www.sec.gov/news/press-release/2021-58.

[76] SEC Press Release, SEC Obtains Emergency Relief, Charges Florida Company and CEO with Misappropriating Investor Money and Operating a Ponzi Scheme (Apr. 26, 2021), available at https://www.sec.gov/news/press-release/2021-74.

The following Gibson Dunn lawyers assisted in the preparation of this client update: Mark Schonfeld and Tina Samanta.

Gibson Dunn is one of the nation’s leading law firms in representing companies and individuals who face enforcement investigations by the Securities and Exchange Commission, the Department of Justice, the Commodities Futures Trading Commission, the New York and other state attorneys general and regulators, the Public Company Accounting Oversight Board (PCAOB), the Financial Industry Regulatory Authority (FINRA), the New York Stock Exchange, and federal and state banking regulators.

Our Securities Enforcement Group offers broad and deep experience. Our partners include the former Director of the SEC’s New York Regional Office, the former head of FINRA’s Department of Enforcement, the former United States Attorneys for the Central and Eastern Districts of California, and former Assistant United States Attorneys from federal prosecutors’ offices in New York, Los Angeles, San Francisco and Washington, D.C., including the Securities and Commodities Fraud Task Force.

Securities enforcement investigations are often one aspect of a problem facing our clients. Our securities enforcement lawyers work closely with lawyers from our Securities Regulation and Corporate Governance Group to provide expertise regarding parallel corporate governance, securities regulation, and securities trading issues, our Securities Litigation Group, and our White Collar Defense Group.

Securities Enforcement Practice Group Leaders:
Richard W. Grime – Washington, D.C. (+1 202-955-8219, rgrime@gibsondunn.com)
Mark K. Schonfeld – New York (+1 212-351-2433, mschonfeld@gibsondunn.com)

Please also feel free to contact any of the following practice group members:

New York
Zainab N. Ahmad (+1 212-351-2609, zahmad@gibsondunn.com)
Matthew L. Biben (+1 212-351-6300, mbiben@gibsondunn.com)
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Joel M. Cohen (+1 212-351-2664, jcohen@gibsondunn.com)
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Alexander H. Southwell (+1 212-351-3981, asouthwell@gibsondunn.com)
Avi Weitzman (+1 212-351-2465, aweitzman@gibsondunn.com)
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Daniel P. Chung (+1 202-887-3729, dchung@gibsondunn.com)
M. Kendall Day (+1 202-955-8220, kday@gibsondunn.com)
Jeffrey L. Steiner (+1 202-887-3632, jsteiner@gibsondunn.com)
Patrick F. Stokes (+1 202-955-8504, pstokes@gibsondunn.com)
F. Joseph Warin (+1 202-887-3609, fwarin@gibsondunn.com)

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Winston Y. Chan (+1 415-393-8362, wchan@gibsondunn.com)
Thad A. Davis (+1 415-393-8251, tadavis@gibsondunn.com)
Charles J. Stevens (+1 415-393-8391, cstevens@gibsondunn.com)
Michael Li-Ming Wong (+1 415-393-8234, mwong@gibsondunn.com)

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Michael D. Celio (+1 650-849-5326, mcelio@gibsondunn.com)
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Robert C. Blume (+1 303-298-5758, rblume@gibsondunn.com)
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Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

On 21 May 2021, the Hong Kong government published the Consultation Conclusions[1] on legislative proposals to enhance anti-money laundering and counter-terrorist financing (“AML/CTF”) regulations in Hong Kong, including a proposal to introduce a licensing regime for virtual asset services providers (“VASPs”). This client alert discusses the proposed scope of the licensing regime, the proposed regulatory requirements for licence holders, implications for cryptocurrency trading platforms, and opportunities for the future development of such trading platforms in Hong Kong.

Note that the discussions in this alert are based on the Consultation Conclusions. While unlikely, there could still be further changes in the drafting of the legislation before the laws are passed. Importantly there will be further public consultation before the detailed regulatory regime for licence holders, including applicable guidelines, are published, as discussed below.

I. Why introduce a licensing regime for VASPs?

In recent years, the world has seen tremendous growth in the trading of virtual assets (“VAs”) including cryptocurrencies like bitcoin. This drew the attention of the Financial Action Task Force (“FATF”), which expressed concern about the perceived money laundering and terrorist financing (“ML/TF”) risks arising from the growing use of VAs. To address these ML/TF risks, the FATF updated the FATF Standards in February 2019[2] to require jurisdictions to subject VASPs to the same range of AML/CTF obligations as financial institutions. To fulfil its obligations as a member of FATF, the Hong Kong government launched a public consultation on 3 November 2020.[3] Amongst other things, the consultation proposed amendments to the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (“AMLO”) to introduce a licensing regime for VASPs. The public consultation period ended on 31 January 2021, and the Consultation Conclusions were published on 21 May 2021.

II. Scope of proposed licensing regime for VASPs

The proposed licensing regime for VASPs would designate the business of operating a VA exchange as a “regulated VA activity”. As such, any person seeking to operate a VA exchange in Hong Kong would be required to apply for a licence[4] from the Hong Kong Securities and Futures Commission (“SFC”) to become a licensed VASP under the AMLO. The granting of the licence would be subject to meeting the SFC’s fit-and-proper test and other regulatory requirements, which we discuss further below.

The proposed definition of a “VA exchange” is any trading platform which:

Is operated for the purpose of allowing an invitation to be made to buy or sell any VA in exchange for any money or any VA; and
Comes into custody, control, power or possession of, or over, any money or any VA at any time during the course of its business.

Accordingly, a peer-to-peer trading platform would not fall within the definition of a VA exchange provided that the actual transactions in VAs are conducted outside the platform and the platform is not involved in the underlying transaction by coming into possession of any money or any VA at any point in time (i.e. platforms that only provide a forum for buyers and sellers to post their bids and offers, where the parties themselves transact outside the platform). As such, on the basis of the current drafting, it is possible that decentralised exchanges (“DEXs”) that operate on the basis of non-custodial storage (as opposed to centralised exchanges where users give up custody of their assets to the exchange) and without a centralised entity in charge of the order book, may not ultimately be caught by the definition of a VA exchange.

The proposed definition of “VA” means a digital representation of value that:

Is expressed as a unit of account or a store of economic value;
Functions (or is intended to function) as a medium of exchange accepted by the public as payment for goods or services or for the discharge of debt, or for investment purposes; and
Can be transferred, stored or traded electronically.

The definition of “VA” is therefore likely to include cryptocurrencies such as bitcoin and VAs backed by another asset for the purpose of stabilising its value (i.e. stablecoins). On the other hand, the definition of VA would not cover:

Digital representations of fiat currencies (such as digital currencies issued by central banks);
Financial products already regulated under the Securities and Futures Ordinance (“SFO”);
Closed-loop, limited purpose items that are non-transferable, non-exchangeable and non-fungible (e.g. air miles, credit card rewards, gift cards, customer loyalty points, gaming coins, etc.); and
Stored value facilities which are regulated under the Payment Systems and Stored Value Facilities Ordinance.

Depending on the final drafting of the legislative amendment to introduce the licensing regime for VASPs, it appears that non-fungible tokens (“NFTs”) may fall outside the definition of “VA”. In that scenario NFT trading platforms would also fall outside the scope of the licensing regime

III. Implications for non-Hong Kong cryptocurrency exchanges

The proposed licensing regime for VASPs would also extend to VA exchanges which operate outside of Hong Kong, but which actively market to the public of Hong Kong. This means that a cryptocurrency exchange that is based outside of Hong Kong will be prohibited from ‘actively marketing’ regulated VA activity (i.e. operating a VA exchange) to the public of Hong Kong unless they are a licensed VASP. This would be similar to existing prohibitions under the SFO[5] on actively marketing regulated activities to the public of Hong Kong (see below). In the context of the SFO, the meaning of actively markets is potentially broad, with some guidance available from the SFC[6] and in case law on its interpretation.

IV. Crypto assets which are securities or futures contracts are already regulated under the SFO

It is important to note that financial products which are already regulated under the SFO would not fall within the definition of “VA”, and therefore trading platforms which enable trading in such products would not fall within the licensing regime for VASPs. An example of such financial products is bitcoin futures which, depending on its terms and features, would likely either fall within the definition of “securities” or “futures contracts” under the SFO (and therefore would not be considered VAs).[7]

However, such trading platforms may already fall within the SFO regulatory regime for providing automated trading services, if it operates in or from Hong Kong, or actively markets to the public in Hong Kong (even if the platforms are based outside of Hong Kong). In this respect, in November 2019, the SFC published a position paper[8] which outlined the regulatory standards for the licensing of trading platforms that enable trading of crypto assets which have “securities” features.

V. Proposed licensing requirements for licensed VASPs

Eligibility: applicants must either be incorporated in Hong Kong, or non-Hong Kong incorporated companies which are registered in Hong Kong under the Companies Ordinance.
Fit-and-proper test: in considering whether or not an applicant is fit-and-proper to be granted a VASP licence, the SFC will take into account, among other matters, whether or not the applicant has been convicted of an ML/TF offence or other offence involving fraud, corruption or dishonesty, their experience and qualifications, their good standing and financial integrity, etc. This fit-and-proper test is likely to be very similar to, if not derived from, the well-established fit-and-proper test which applicants are required to satisfy to be granted a regulated activity licence under the SFO.
Two responsible officers: as with any firm currently licensed by the SFC, applicants will need to appoint at least two responsible officers to assume the responsibility of ensuring compliance with AML/CTF and other regulatory requirements, who may be held personally accountable in case of non-compliance.

VI. Regulatory requirements for licensed VASPs

Licensed VASPs will be subject to the AML/CTF requirements stipulated in Schedule 2 of the AMLO (i.e. the same as financial institutions), including customer due diligence and record-keeping requirements.

In addition to AML/CTF requirements, licensed VASPs will also be subject to regulatory requirements designed to protect market integrity and investor interests. These requirements will be set out in codes and guidelines to be published by the SFC. Licensed VASPs would be required to comply with these requirements under licensing conditions imposed by the SFC. These requirements are likely to be wide-ranging in scope, with prescribed requirements covering, among other things, financial resources, risk management, segregation and management of client assets, financial reporting, prevention of market manipulative and abusive activities, prevention of conflicts of interest, etc.

Notably, licensed VASPs will only be able to provide services to professional investors, i.e. high net worth and institutional investors. This means that after the commencement of the licensing regime for VASPs, licensed VASPs cannot provide services to retail investors.

VII. Supervisory powers of the SFC over licensed VASPs

The SFC will be given broad powers to supervise the AML/CTF and regulatory compliance of licensed VASPs. This will include powers to enter business premises, to request the production of documents and records, to investigate non-compliance and to impose sanctions (including orders for remedial actions, civil penalties and suspension or revocation licence) for non-compliances. The SFC will also have intervention powers to impose restrictions and prohibitions against the operations of licensed VASPs and their associated entities where the circumstances warrant, such as to prohibit further transactions or restrict the disposal of property. These powers enable the SFC to protect client assets in the event of emergency and to prevent the dissipation of client assets in the case of misconduct by a licensed VASP.

VIII. Timing

The Hong Kong government aims to introduce the AMLO amendment bill into the Legislative Council in the 2021-22 legislative session, which is due to commence in October 2021. The SFC will also prepare and publish for consultation the regulatory requirements for licensed VASPs, before commencement of the licensing regime for VASPs. Considering the above, the licensing regime is unlikely to commence before 2022. In any event there will be a 180-day transitional period from the commencement of the licensing regime to facilitate licence applications by interested parties.

IX. Conclusion

While the primary motivation for introducing the licensing regime for VASPs is to ensure that Hong Kong meets the latest FATF Standards, the Hong Kong authorities are also focused on promoting the protection of market integrity and investor interests, and the regulatory requirements for licensed VASPs extend beyond AML/CTF requirements by seeking to regulate matters including customer type (i.e. professional investors only), prevention of market manipulative and abusive activities, and prevention of conflicts of interest.

As Mr. Christopher Hui, Secretary for Financial Services and the Treasury, recently said in his remarks at a fintech forum,[9] the introduction of the licensing regime for VASPs is intended to facilitate the development of such an industry by providing a clear regulatory framework for the industry to operate within. Notably, the original proposal for the licensing regime has now been amended to allow non-Hong Kong companies to apply for a VASP licence[10] which may help to attract overseas crypto asset trading platforms that wish to develop their business within the Hong Kong regulatory framework.

For current VASPs contemplating applying for a VA licence when the licensing regime commences, we would recommend starting by reviewing their existing AML/CTF policies and systems and controls to identify gaps with the requirements under Schedule 2 of the AMLO. This is because these requirements are unlikely to be significantly modified during the legislative process, and it may take time and resources to design and implement. VASPs should also be alert to future consultations by the SFC on the codes and guidelines for licensed VASPs in order to identify the detailed regulatory requirements which licensed VASPs would need to comply with. Implementing these requirements will likely require preparing written policies and procedures, upgrading systems and controls, and potentially restructuring aspects of their business and operations to address potential conflicts of interest.

__________________________

[1] Consultation Conclusions on Public Consultation on Legislative Proposal to Enhance Anti-Money Laundering and Counter-Terrorist Financing Regulation in Hong Kong (May 2021), published by the Financial Services and the Treasury Bureau, available at: https://www.fstb.gov.hk/fsb/en/publication/consult/doc/consult_conclu_amlo_e.pdf

[2] Public Statement – Mitigating Risks from Virtual Assets (22 February 2019), published by FATF, available at: https://www.fatf-gafi.org/publications/fatfrecommendations/documents/regulation-virtual-assets-interpretive-note.html

[3] Government launches consultation on legislative proposal to enhance anti-money laundering and counter-terrorist financing regulation (3 November 2020), Hong Kong government press release, available at: https://www.info.gov.hk/gia/general/202011/03/P2020110300338.htm

[4] There will be an exception for a VA exchange that is already regulated as a licensed corporation in the voluntary opt-in regime supervised by the SFC pursuant to the SFO.

[5] Section 115 of the SFO.

[6] “Actively markets” under section 115 of the SFO (last updated 17 March 2003), published by the SFC, available at: https://www.sfc.hk/en/faqs/intermediaries/licensing/Actively-markets-under-section-115-of-the-SFO#9CAC2C2643CF41458CEDA9882E56E25B

[7] Circular to Licensed Corporations and Registered Institutions on Bitcoin futures contracts and cryptocurrency-related investment products (11 December 2017), published by the SFC, available at: https://apps.sfc.hk/edistributionWeb/gateway/EN/circular/doc?refNo=17EC79

[8] Position paper: Regulation of virtual asset trading platforms (6 November 2019), published by the SFC, available at: https://www.sfc.hk/-/media/EN/files/ER/PDF/20191106-Position-Paper-and-Appendix-1-to-Position-Paper-Eng.pdf

[9] Secretary for Financial Services and the Treasury, Mr. Christopher Hui, remarks at StartmeupHK Festival – Virtual FinTech Forum on 27 May 2021, available at: https://www.news.gov.hk/eng/2021/05/20210527/20210527_131949_094.html

[10] The non-Hong Kong incorporated company would need to be registered in Hong Kong under the Companies Ordinance.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. If you would like to discuss further, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Financial Institutions practice group, or the following authors:

Connell O’Neill – Hong Kong (+852 2214 3812, coneill@gibsondunn.com)
Sébastien Evrard – Hong Kong (+852 2214 3798, sevrard@gibsondunn.com)
Arnold Pun – Hong Kong (+852 2214 3838, apun@gibsondunn.com)

Please also feel free to contact any of the following practice leaders and members:

Matthew L. Biben – New York (+1 212-351-6300, mbiben@gibsondunn.com)
Michael D. Bopp – Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com)
Stephanie Brooker – Washington, D.C. (+1 202-887-3502, sbrooker@gibsondunn.com)
M. Kendall Day – Washington, D.C. (+1 202-955-8220, kday@gibsondunn.com)
Mylan L. Denerstein – New York (+1 212-351- 3850, mdenerstein@gibsondunn.com)
Michelle M. Kirschner – London (+44 (0) 20 7071 4212, mkirschner@gibsondunn.com)
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Matthew Nunan – London (+44 (0) 20 7071 4201, mnunan@gibsondunn.com)
Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com)

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

This week, there were important virtual currency developments at two of the principal federal banking agencies, the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC). Both of these developments occurred as the markets for digital currencies showed substantial volatility. First, in testimony before Congress on Wednesday, Acting Comptroller of the Currency Michael Hsu expressed concerns about the OCC’s recent actions for digital currency companies and stated that he had “asked staff to review these actions.”[1] Second, the FDIC published a request for information (RFI) about digital assets and the banking system.[2] Comments on the RFI are due by July 16, 2021.

I. Office of the Comptroller of the Currency

Prior to Acting Comptroller Hsu’s appointment by Treasury Secretary Yellen, the OCC was the federal banking agency that had taken the lead on digital currencies, recently approving three applications by digital currency companies. Of these actions, Acting Comptroller Hsu stated his “broad[] concern . . . that these initiatives were not done in full coordination with all stakeholders. Nor do they appear to have been part of a broader strategy related to the regulatory perimeter.”[3]

The OCC approvals involved two applications for conversion from state trust companies to national trust banks, those of Anchorage Digital Bank, National Association, and Protego Trust Bank, National Association, and one application for a new national trust bank charter, for Paxos National Trust.[4] Each approval therefore involved a type of national bank specifically authorized by Congress, and not a special purpose “fintech” charter.

The activities that the OCC stated were permissible for national banks in the approvals covered many digital currency activities, including:

fiduciary custody of digital assets
custody of client cash deposits
providing on-chain governance services allowing clients to participate in the governance of the underlying protocols on which their digital assets operate
operating validator nodes
providing staking as a service
providing clients the ability to delegate staking to third-party validators
settling transactions facilitated by affiliates, third-party brokers and clients
determining that customers should claim forked assets
custody and management of U.S. dollar stablecoin reserves
payment, exchange, and other agent services
trading services and enabling partners to buy and sell cryptocurrency
“know your customer” as a service, including customer identification, sanctions screening, enhanced due diligence, customer risk rating, and other related services[5]

It is not clear what form the OCC staff review mandated by Acting Comptroller Hsu will take. It does appear from the rest of his testimony, however, that the OCC will no longer “go it alone” when it comes to digital assets. As Mr. Hsu – formerly a career supervisor at the Federal Reserve – stated, “[r]ecognizing the OCC’s unique authority to grant charters, we must find a way to consider how fintechs and payments platforms fit into the banking system, and we must do it in coordination with the FDIC, Federal Reserve, and the states.”[6] Mr. Hsu also warned of the potential of systemic risk from digital activities, stating that he was feeling “some déjà vu,” having seen the financial disintermediation of the late 1990s and 2000s that contributed to the Great Recession.[7]

II. Federal Deposit Insurance Corporation

If the OCC appears to be putting on the brakes, the FDIC – the primary federal supervisor for insured state banks, including industrial banks, that are not members of the Federal Reserve system, the U.S. deposit insurer, and the U.S. bank resolution authority – signaled that it wishes to know more about digital assets and the banking system. On May 17, it issued a request for information, soliciting comments regarding insured depository institutions’ (IDIs) current and potential digital asset activities.[8] The FDIC noted that banks are exploring several roles in the digital asset ecosystem, with digital use cases and related activities potentially falling into the following categories:

Technology solutions, such as those involving closed and open payment systems, other token-based systems for banking activities other than payments (g., lending), and acting as nodes in networks (e.g., distributed ledgers)
Asset-based activities, such as investments, collateral, margin lending and liquidity facilities
Liability-based activities, such as deposit services and where deposits serve as digital asset reserves
Custodial activities, such as providing digital asset safekeeping and related services, such as secondary lending, as well as acting as a qualified custodian on behalf of investment advisors
Other activity including market-making and decentralized financing

Current and Potential Use Cases

The RFI seeks information regarding current and potential use cases of digital assets, including categories of digital assets and related activities, activities or use cases that IDIs are currently engaging in or considering, and the demand for digital asset-related services.

Risk and Compliance Management

The RFI asks for comment regarding risk and compliance management, including IDIs’ existing risk and compliance management frameworks; unique risks that are challenging to measure, monitor, and control for the various digital asset use cases; unique benefits to operations from the various digital asset use cases; the integration of operations related to digital assets with legacy banking systems; potential benefits and unique risks of particular digital asset product offerings or services to IDI customers; and the integration of new technologies into existing cybersecurity functions.

Supervision and Activities

The RFI requests information regarding supervision and activities, including the unique aspects of digital asset activities that the FDIC should take into account from a supervisory perspectives; areas in which the FDIC should clarify or expand existing supervisory guidance to address digital asset activities; the difference between the custody of digital assets and the custody of traditional assets; and the interaction of digital assets with the FDIC’s Part 362 application procedures, which cover applications by insured state nonmember banks to conduct principal activities that have not been approved for national banks.

Deposit Insurance and Resolution

The RFI asks for information regarding deposit insurance and resolution, including steps to ensure customers can distinguish between uninsured digital asset products and insured deposits; distinctions or similarities between fiat-backed stablecoins and stored value products where the underlying funds are held at IDIs and for which pass-through deposit insurance may be available; and complexities that might be encountered in valuing, marketing, operating, or resolving digital asset activity in the resolution process or in a receivership capacity.

Conclusion

This week’s actions demonstrate that, as the Biden Administration takes shape, there is a change in banking agency approach to digital assets and that addressing the issues raised by digital assets remains a considerable regulatory priority. It appears that the OCC, Federal Reserve Board and FDIC will take a more coordinated approach to digital assets, one result of which may be that certain state bank regulatory agencies may take the lead on innovative proposals in the short term. For example, most of the activities that the OCC permitted in its digital currency approvals before Acting Comptroller Hsu was appointed had previously been deemed permissible for state-licensed trust companies.

____________________

[1] Statement of Michael J. Hsu, Acting Comptroller of the Currency, Committee on Financial Services, United States House of Representatives, May 19, 2021 (Hsu Statement).

[2] FDIC, Request for Information and Comment on Digital Assets (May 17, 2021), available at https://www.fdic.gov/news/press-releases/2021/pr21046a.pdf.

[3] Hsu Statement.

[4] Letter from Stephen A. Lybarger, Deputy Comptroller Licensing, OCC, to Nathan McCauley, President & Director, Anchorage Trust Company, Application by Anchorage Trust Company, Sioux Falls, South Dakota to Convert to a National Trust Bank (Jan. 13, 2021); Letter from Stephen A. Lybarger, Deputy Comptroller Licensing, OCC, to Greg Gilman, Founder & Executive Chair, Audaces Fortuna Inc., Application by Protego Trust Company, Seattle, Washington, to Convert to a National Trust Bank (Feb. 4, 2021); Letter from Stephen A. Lybarger, Deputy Comptroller Licensing, OCC, to Daniel Burstein, General Counsel and Chief Compliance Officer, Paxos, Application to Charter Paxos National Trust, New York, New York (Apr. 23, 2021).

[5] See id., available at https://www.occ.gov/news-issuances/news-releases/2021/nr-occ-2021-6a.pdf; https://www.occ.gov/news-issuances/news-releases/2021/nr-occ-2021-19a.pdf; and https://www.occ.gov/news-issuances/news-releases/2021/nr-occ-2021-49a.pdf.

[6] Hsu Statement.

[7] Hsu Statement

[8] FDIC, Request for Information and Comment on Digital Assets (May 17, 2021), available at https://www.fdic.gov/news/press-releases/2021/pr21046a.pdf?source=govdelivery&utm_medium=email&utm_source=govdelivery.

The following Gibson Dunn lawyers assisted in preparing this client update: Arthur Long and Samantha Ostrom.

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, the authors, or any of the following members of the firm’s Financial Institutions practice group:

Matthew L. Biben – New York (+1 212-351-6300, mbiben@gibsondunn.com)
Michael D. Bopp – Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com)
Stephanie Brooker – Washington, D.C. (+1 202-887-3502, sbrooker@gibsondunn.com)
M. Kendall Day – Washington, D.C. (+1 202-955-8220, kday@gibsondunn.com)
Mylan L. Denerstein – New York (+1 212-351- 3850, mdenerstein@gibsondunn.com)
Michelle M. Kirschner – London (+44 (0) 20 7071 4212, mkirschner@gibsondunn.com)
Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com)
Matthew Nunan – London (+44 (0) 20 7071 4201, mnunan@gibsondunn.com)
Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com)

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

Each month, Gibson Dunn’s Media, Entertainment and Technology Practice Group highlights notable developments and rulings that may impact future litigation in this area. This month we focus on the increasingly popular digital asset known as non-fungible tokens or “NFTs” and related issues in the entertainment space and beyond.

Issue: Non-Fungible Tokens (NFTs)

Summary: NFTs have gone mainstream in what some have called a new “gold rush.” An NFT sold for almost $70 million at a Christie’s auction last month, NFTs of basketball video highlights have generated hundreds of millions of dollars in sales on the NBA Top Shot platform, and NFTs even were the subject of a skit on a recent episode of Saturday Night Live. Some consider them a fad or a bubble, citing the almost $600,000 sale of an image of an animated flying cat with a pop-tart body that anyone can download from the internet for free. But in one form or another, NFTs are here to stay. Even if the market matures and interest wanes in some unconventional pieces of digital art, NFTs will continue to offer a significant potential revenue stream for artists and entities in the film and television, music, and online gaming industries, among many others. We highlight below some of the emerging legal and policy issues related to NFTs, which include intellectual property law, profit participation issues, securities law, and even climate change.

What do the music group Megadeth, former University of Iowa basketball player Luka Garza, and New York City track and field center The Armory have in common? In the span of 24 hours earlier this month, each of them entered the rapidly expanding NFT market. They joined a number of artists and entertainers who have led the charge in selling NFTs. As film studios and other entities with large content libraries consider following suit, they will need to consider a number of deeply rooted legal issues against a relatively new technological backdrop.

I. Background

There are widely varied understandings of NFTs and related issues concerning tokens and blockchain technology. While many of our readers are familiar with these terms, a brief introduction is helpful to frame the issues that follow.

A. What are NFTs and What is the Blockchain?

An NFT, or “non-fungible token,” is a unique unit of data stored on a public ledger of transactions called a blockchain. The unique data could represent an image, an electronic deed to a piece of property, or a digital ticket for a particular seat at a sporting event. In contrast to these “non-fungible” tokens, cryptocurrencies such as Bitcoin and Ether—just like U.S. dollars, British pounds and other “fiat” government-issued currencies—are fungible; one penny in your pocket has the same intrinsic value as the penny under your couch cushion.

Today, NFTs generally reside on the Ethereum blockchain, which also supports, among other things, the cryptocurrency Ether—the second largest cryptocurrency in terms of market capitalization and volume after Bitcoin. While other blockchains can have their own versions of NFTs, right now Ethereum is the most widely used (though NBA Top Shot uses the Flow blockchain).

But what is a blockchain? As noted above, it is an electronic database or ledger showing a history of transactions. Each transaction is represented by an entry into the electronic ledger and multiple ledger entries are ordered in data batches known as “blocks” to await verification on the network. New blocks are added after the current block reaches its data limit. The blocks are connected using cryptography: each block contains a “hash” (a sort of coded electronic signature linking it to the previous block), which is how the blockchain gets its name.

A key feature of the Ethereum blockchain that distinguishes it from a database one might have at a business or law firm is that the blockchain is decentralized across a community of servers. Data is not stored in any one location or managed by any particular body. Rather, it exists on multiple computers simultaneously, with network participants holding identical copies of the ledger reflecting the encrypted transactions.

That is why blockchains are touted as both verifiable and secure. It is similar to the tracking details showing each step in a package’s journey from the shipper to its final delivery destination. Unlike the tracking details provided by a shipping company, however, on the blockchain no one person can alter that record to change the encrypted data without the network’s users noticing and rejecting the fraudulent version. And if any one computer system fails, there are duplicate images of the tracking details on the blockchain ledger available on other computers around the world.

B. What Do You Get When You Buy An NFT?

While an NFT is unique, it is important to keep in mind what that unique digital item actually is. In most cases the NFT is a digital identifier recording ownership, not—to borrow an example from the above—the actual image of the pop-tart cat. What amounts to your “receipt” is reflected in the blockchain, but the image file itself resides elsewhere.

This has to do with blockchain storage limitations and costs. The digital image itself theoretically can be stored in metadata on the blockchain, but in the vast majority of cases it is hosted on a regular website or the decentralized InterPlanetary File System (IPFS). The identifier is logged on the blockchain, but if the image is taken down from its non-blockchain location—say, because it violates someone’s copyright—the NFT could end up being a unique digital path to a closed door (even if there may be seemingly identical “copies” of the digital asset elsewhere). The immutable purchase record would remain on the blockchain, but the original image might not be viewable.

Almost uniformly, the NFT transfer conveys an interest in a licensed copy while copyright ownership of the underlying image or song is not transferred. The NFT may be in a limited edition and it may have some additional perceived value because it is officially authorized by the copyright holder or originated from the address of the copyright holder. But while the underlying copyright can be transferred when the NFT is sold or licensed, typically it isn’t. The terms and conditions of an NFT platform may reveal the limits of what actually is being transferred and how it might be used.

Under NBA Top Shot’s terms, for example, the purchaser who obtains a license to a “Moment” cannot use it for a commercial purpose, modify it, or use the image alongside anything the NBA considers offensive or hateful. An NFT platform that controls the image file is able to remove that file from its platform.

* * *

Monetization strategies for NFTs are constantly evolving, so one cannot generalize and say that all NFTs fall in one legal bucket or another. An NFT can be fair use of a copyright or it can violate it. An NFT likewise could be a simple collectible or it may be offered in such a way to convert it into a security subject to myriad regulations and disclosure requirements. It depends on the NFT. But as the market evolves, complicated questions will need to be answered by NFT creators, platforms, and, potentially, courts.

II. Intellectual Property

Any NFT platform must be particularly focused on the intellectual property rights underlying the NFTs stored, sold, or licensed on the platform. A single NFT may include various copyrightable elements, including a video clip and any accompanying music. Whereas the platform may be able to invoke a statutory liability protection with respect to some potential claims—like defamation—certain intellectual property claims are not precluded.

Specifically, Section 230 of the Communications Decency Act of 1996 shields certain online service providers from liability for hosting content that someone else created. In particular, Section 230(c)(1) states that “No provider or user of an interactive computer service shall be treated as the publisher or speaker of any information provided by another information content provider.”

To the extent Section 230 applies to a particular NFT platform, the law’s broad protection still has carve-outs. Among other things, it does not apply to “any law pertaining to intellectual property.” Courts have different interpretations of the scope of Section 230’s reference to “intellectual property.” In Perfect 10 v. CCBill, 488 F.3d 1102 (9th Cir. 2007), the Ninth Circuit ruled that Section 230 permitted claims under federal intellectual property laws but preempted state intellectual property claims alleging a violation of the plaintiff’s right of publicity. In Atlantic Recording Corp. v. Project Playlist, Inc., 603 F. Supp. 2d 690 (S.D.N.Y. 2009), a Southern District of New York court reached the opposite conclusion, holding that the “intellectual property” carve-out extended beyond intellectual property claims under federal law to include state-law claims.

Whether or not an NFT platform would be subject to potential liability for violating someone’s state-law right in her or his name and likeness, federal intellectual property law still would apply. And offering an NFT that potentially infringes a copyright could result in liability for the platform if, for example, it does not take the necessary steps under the Digital Millennium Copyright Act. That risk is heightened for some platforms given how easy it is to tokenize someone else’s work. Speculators can turn any digital image into an NFT that they can then try to sell, even if the original creator does not agree to that use or even know about it.

Studios and other intellectual property rights holders will need to be especially vigilant in protecting their intellectual property—and NFT platforms likewise will need to promptly remove content if a copyright owner notifies it of an infringement—as the market for small pieces of content expands.

III. Profit Participations

Especially in the current NFT environment, it is not difficult to imagine the potential value of tokenized iconic moments from movies and television. Of course, there would be a number of contractual issues for a rightsholder to navigate, which would vary from deal to deal. Valuable clips might come from movies dating back long before the advent of NFTs, the internet, or even computers. The relevant agreements certainly would not address NFTs, but even analogous provisions might be difficult to identify. Agreements may refer to “clips,” for example, but typically a clip is used to promote the full program or film rather than to be monetized on its own.

Depending on what it depicts, an NFT might not be a “clip” at all. Again using NBA Top Shot as an example, a “Moment” is not just a short video excerpt showing a pass or dunk; it is a package of on-court video, still photographs, digital artwork, and game information. Contracts would need to be analyzed to determine if the NFT should be categorized as a clip, a derivative production, merchandising, promotional material, or something else, with potential consequences on the calculation of gross receipts and any corresponding rights to profit participations or Guild royalties.

Exclusivity provisions in film or television licenses to third parties might bar or limit a studio from “minting” an NFT from a work in its library. Other considerations might also limit a rightsholder’s willingness to enter the NFT space. With vast libraries of well-known and high‑quality content, however, studios are better positioned than most to take advantage of the increased interest and marketability of discrete portions of a film or program.

IV. Securities Law

Particularly in light of the SEC’s increased focus on cryptocurrencies, including its recent lawsuit accusing Ripple Labs Inc. and two of its executives of engaging in an unregistered “digital asset securities offering,” anyone involved in marketing an NFT should give careful consideration to whether the NFT is a security under U.S. law.

This should be of particular concern to the celebrities marketing their own NFTs. Several years ago, in response to celebrity endorsements for cryptocurrency Initial Coin Offerings (ICOs), the SEC warned that “[a]ny celebrity or other individual who promotes a virtual token or coin that is a security must disclose the nature, scope, and amount of compensation received in exchange for the promotion.”[1] A failure to do so would be “a violation of the anti-touting provisions of the federal securities laws.”[2] The same principle would apply to NFTs, with the key question being whether an NFT is a security. This issue has significant bearing on the NFT platform as well. If an NFT is a security, the offeror must follow securities law disclosure requirements and restrictions on who may invest.

The term “security” in U.S. securities laws includes an “investment contract” as well as other instruments like stocks and bonds. Both the SEC and federal courts often use the “investment contract” analysis to determine whether unique instruments, such as digital assets, are securities subject to federal securities laws.

To determine whether a digital asset has the characteristics of an investment contract, courts apply a test derived from the U.S. Supreme Court’s decision in SEC v. W.J. Howey Co., 328 U.S. 293 (1946). Under that Howey test, federal securities laws apply where

there is an investment of money or some other consideration,
in a common enterprise,
with a reasonable expectation of profits,
to be derived from the efforts of others.

Again, it would depend on the NFT, but transactions that resemble a fan buying a collectible likely would not be securities under this test. The notion that an NFT is non-fungible also makes it less likely to be a security.

Nevertheless, the NFT market is a creative one. Many NFTs, for example, are configured through the “smart contracts”—which are essentially computer programs—to automatically pay out royalties to the digital artwork’s original creator with every future sale of the NFT on that platform; the artist could package those royalty rights for sale to potential investors.

NFT issuers also can sell fractional interests in NFTs or groups of NFTs. As prices for some NFTs climb into the stratosphere, this approach becomes more appealing to potential buyers who want a piece of the NFT but are unwilling or unable to pay for the whole thing. According to recent statements by SEC Commissioner Hester Peirce, however, doing so increases the likelihood that the NFT would be deemed a security under the Howey test.[3] That likelihood grows where the NFT issuer or a third party claim to be able to help increase the NFT’s value.

V. Climate Change

A major issue that has arisen related to NFTs— and cryptocurrency generally—is their believed effect on the environment. Articles abound comparing the energy consumption of the Ethereum blockchain to entire countries. An analysis by Cambridge University asserts that what it calls the “Bitcoin network” uses more energy than Argentina.[4] NFTs thus have proven somewhat controversial, with one online marketplace for digital artists dropping its plans to launch an NFT platform after backlash that included an artist labeling NFTs an “ecological nightmare pyramid scheme.”[5]

Some contend that these ecological concerns are exaggerated and misleading, noting that NFTs themselves do not cause carbon emissions. As one platform wrote in a recent blog post, “Ethereum has a fixed energy consumption at a given point of time.”[6] The carbon footprint of the Ethereum blockchain would be the same if people minted more NFTs or stopped minting them altogether. But even the post acknowledges that “[i]t is true that Ethereum is energy intensive.”[7]

The crypto energy consumption issue relates to how blockchain technology currently operates. To validate a transaction—and engender trust in a system that is not backed by any central bank or other government authority—the blockchain network relies on a method called “Proof of Work.” The hashing function described above that allows the blocks to be chained together requires complex mathematical equations that only powerful computers can solve. “Miners” must solve these equations to add a new block to the chain. As incentive to solve the mathematical puzzles, the miner receives a reward of new tokens or transaction fees.

The energy costs to complete the hash functions under the Proof of Work model can be high, with miners using entire data centers to compete to solve the puzzles first and garner the reward. To mitigate any environmental effects, mining sites may increasingly rely on renewable energy and “stranded” energy, which is surplus energy created, for example, by excess power that some hyrdroelectric dams around the world generate during rainy seasons.

Another option, at least for the Ethereum blockchain, is moving to a “Proof of Stake” model. Rather than relying on miners using significant amounts of electricity in a race to solve an equation the fastest, the Proof of Stake model involves validators of transactions who are assigned randomly via an algorithm. These validators also have to commit some of their own cryptocurrency, giving them a “stake” in keeping the blockchain accurate.

Reports indicate that Ethereum may move to the Proof of Stake model as soon as this year.[8] Doing so would decrease energy consumption associated with NFTs, allow more transactions per second than in the Proof of Work model, and seemingly remove (or at least mitigate) an apparent drag on the willingness of some to embrace NFTs.

At the same time, one recent article noted what a crypto-mining finance company executive called the “‘inherent security issue of using the native tokens of a blockchain to decide the future of those tokens or the blockchain.’”[9] If the value of the tokens fall, the value of a validator’s stake falls along with it. The validator then has less to lose if they decide to propose an incorrect transaction or otherwise misbehave.

VI. Conclusion

NFTs present significant opportunities for content creators and owners, but they also present novel legal and policy issues across a wide range of areas as the technology continues to evolve. Beyond those listed here, areas of potential concern include Commodities/Derivatives, Tax, Data Privacy, and Cross-Border Transactions. Understanding the potential complications of moving into the NFT space is a necessity in anticipation of the regulatory scrutiny and litigation that often follow similar explosions of interest and investment.

_______________________

[1] https://www.sec.gov/news/public-statement/statement-potentially-unlawful-promotion-icos (Nov. 1, 2017).

[2] Id.

[3] https://cointelegraph.com/news/sec-s-crypto-mom-warns-selling-fractionalized-nfts-could-break-the-law (Mar. 26, 2021).

[4] https://www.bbc.com/news/technology-56012952 (Feb. 10, 2021).

[5] https://www.theverge.com/2021/3/15/22328203/nft-cryptoart-ethereum-blockchain-climate-change (Mar. 15, 2021).

[6] https://medium.com/superrare/no-cryptoartists-arent-harming-the-planet-43182f72fc61 (Mar. 2, 2021).

[7] Id.

[8] https://www.coindesk.com/ethereum-proof-of-stake-sooner-than-you-think (Mar. 17, 2021).

[9] https://cryptonews.com/exclusives/proof-of-disagreement-bitcoin-s-work-vs-ethereum-s-planned-s-9788.htm (Apr. 3, 2021).

The following Gibson Dunn lawyers assisted in the preparation of this client update: Michael Dore and Jeffrey Steiner.

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 the following leaders and members of the firm’s Media, Entertainment & Technology Practice Group:

Scott A. Edelman – Co-Chair, Media, Entertainment & Technology Practice, Los Angeles (+1 310-557-8061, sedelman@gibsondunn.com)
Kevin Masuda – Co-Chair, Media, Entertainment & Technology Practice, Los Angeles (+1 213-229-7872, kmasuda@gibsondunn.com)
Orin Snyder – Co-Chair, Media, Entertainment & Technology Practice, New York (+1 212-351-2400, osnyder@gibsondunn.com)
Brian C. Ascher – New York (+1 212-351-3989, bascher@gibsondunn.com)
Michael H. Dore – Los Angeles (+1 213-229-7652, mdore@gibsondunn.com)
Howard S. Hogan – Washington, D.C. (+1 202-887-3640, hhogan@gibsondunn.com)
Ilissa Samplin – Los Angeles (+1 213-229-7354, isamplin@gibsondunn.com)
Nathaniel L. Bach – Los Angeles (+1 213-229-7241,nbach@gibsondunn.com)

Please also feel free to contact the following members of the firm’s Digital Currencies and Blockchain Technology team:

Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com)
Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com)
Stephanie Brooker – Washington, D.C. (+1 202-887-3502, sbrooker@gibsondunn.com)
M. Kendall Day – Washington, D.C. (+1 202-955-8220, kday@gibsondunn.com)
Thomas J. Kim – Washington, D.C. (+1 202-887-3550, tkim@gibsondunn.com)
Judith Alison Lee – Washington, D.C. (+1 202-887-3591, jalee@gibsondunn.com)
Alexander H. Southwell – New York (+1 212-351-3981, asouthwell@gibsondunn.com)
S. Ashlie Beringer – Palo Alto (+1 650-849-5327, aberinger@gibsondunn.com)
Michael H. Dore – Los Angeles (+1 213-229-7652, mdore@gibsondunn.com)

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

On February 18, 2021, the U.S. Office of Foreign Assets Control (OFAC), an agency of the Treasury Department that administers and enforces U.S. economic and trade sanctions, issued an enforcement release of a settlement agreement with BitPay, Inc. (BitPay) for apparent violations relating to Bitpay’s payment processing solution that allows merchants to accept digital currency as payment for goods and services.[1] OFAC found that BitPay allowed users apparently located in sanctioned countries and areas to transact with merchants in the United States and elsewhere using the BitPay platform, even though BitPay had Internet Protocol (IP) address data for those users. The users in sanctioned countries were not BitPay’s direct customers, but rather its customer’s customers (in this case the merchants’ customers).

The BitPay action follows an OFAC December 30, 2020 enforcement release of a settlement agreement with BitGo, Inc. (BitGo), also for apparent violations related to digital currency transactions.[2] BitGo offers, among other services, non-custodial secure digital wallet management services, and OFAC found that BitGo failed to prevent users located in the Crimea region of Ukraine, Cuba, Iran, Sudan and Syria from using these services. OFAC determined that BitGo had reason to know the location of these users based on IP address data associated with the devices used to log into its platform.

This Alert discusses these developments.

I. OFAC’s Enforcement Against BitGo

BitGo, which was founded in 2013 and is headquartered in Palo Alto, California, is self-described as “the leader in digital asset financial services, providing institutional investors with liquidity, custody, and security solutions.”[3] As OFAC explained in its enforcement release, the company agreed to remit $98,830 to settle potential civil liability related to 183 apparent violations of multiple sanctions programs. OFAC specifically claimed that between 2015 and 2019, deficiencies in BitGo’s sanctions compliance procedures led to BitGo’s failing to prevent individuals located in the Crimea region of Ukraine, Cuba, Iran, Sudan, and Syria from using BitGo’s non-custodial secure digital wallet management service despite having reason to know that these individuals were located in sanctioned jurisdictions. Reason to know was based on BitGo’s having IP address data associated with the devices that these individuals used to log in to the BitGo platform. According to OFAC, BitGo processed 183 digital currency transactions on behalf of these individuals, totaling $9,127.79.

According to the OFAC release, prior to April 2018, BitGo had allowed individual users of its digital wallet management services to open an account by providing only a name and email address. In April 2018, BitGo supplemented this practice by requiring new users to verify the country in which they were located, with BitGo generally relying on the user’s attestation regarding his or her location rather than performing additional verification or diligence on the user’s location. In January 2020, however, BitGo discovered the apparent violations of multiple sanctions compliance programs. It thereupon implemented a new OFAC Sanctions Compliance Policy and undertook significant remedial measures. This new policy included appointing a Chief Compliance Officer, blocking IP addresses for sanctioned jurisdictions, and keeping all financial records and documentation related to sanctions compliance efforts.

II. OFAC’s Enforcement Against BitPay

BitPay, which was founded in 2011 and is headquartered in Atlanta, Georgia, provides digital asset management and payment services that enable consumers “to turn digital assets into dollars for spending at tens of thousands of businesses.”[4] As OFAC explained in its enforcement release, BitPay agreed to remit $507,375 to settle potential civil liability related to 2,102 apparent violations of multiple sanctions programs. OFAC specifically claimed that between 2013 and 2018, deficiencies in BitPay’s sanctions compliance procedures led to BitPay’s allowing individuals who appear to have been located in the Crimea region of Ukraine, Cuba, North Korea, Iran, Sudan, and Syria to transact with merchants in the United States and elsewhere using digital currency on BitPay’s platform despite BitPay having location data, including IP addresses, about those individuals prior to effecting the transactions.

BitPay allegedly “received digital currency payments on behalf of its merchant customers from those merchants’ buyers who were located in sanctioned jurisdictions, converted the digital currency to fiat currency, and then relayed that currency to its merchants.” According to OFAC, BitPay processed 2,102 such transactions totaling $128,582.61. Although BitPay had (i) screened its direct customers (i.e., its merchant customers) against OFAC’s List of Specially Designated Nationals and Blocked Persons and (ii) conducted due diligence on the merchants to ensure they were not located in sanctioned jurisdictions, BitPay failed to screen location data that it obtained about its merchants’ buyers—BitPay had begun receiving buyers’ IP address data in November 2017, and prior to that received information that included buyers’ addresses and phone numbers. BitPay had implemented sanctions compliance controls as early as 2013, including conducting due diligence and sanctions screening on its merchants, and formalized its sanctions compliance program in 2014. However, following its apparent violations, BitPay supplemented its program with the following:

Blocking IP addresses that appear to originate in Cuba, Iran, North Korea, and Syria from connecting to the BitPay website or from viewing any instructions on how to make payment;
Checking physical and email addresses of merchants’ buyers when provided by the merchants to prevent completion of an invoice from the merchant if BitPay identifies a sanctioned jurisdiction address or email top-level domain; and
Launching “BitPay ID,” a new customer identification tool that is mandatory for merchants’ buyers who wish to pay a BitPay invoice equal to or above $3,000. As part of BitPay ID, the merchant’s customer must provide an email address, proof of identification/photo ID, and a selfie photo.

III. Conclusion

The major takeaway from these two enforcement cases is that OFAC expects digital asset companies to use IP address data or other location data—even for their customers’ customers—to screen that location information as part of their OFAC compliance function. OFAC will undoubtedly be considering whether a company has screened such information in assessing whether to impose a penalty. More guidance on OFAC’s perspective on the essential components of a sanctions compliance program is available in A Framework for OFAC Compliance Commitments, which OFAC published in May 2019. In addition, we anticipate ongoing scrutiny by OFAC of digital asset companies, given that key Treasury Department policymakers continue to express concerns about digital assets being used to avoid economic sanctions and anti-money laundering compliance.[5]

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[1] OFAC Enters Into $507,375 Settlement with BitPay, Inc. for Apparent Violations of Multiple Sanctions Programs Related to Digital Currency Transactions (Feb. 18, 2021), available at https://home.treasury.gov/system/files/126/20210218_bp.pdf.

[2] OFAC Enters Into $98,830 Settlement with BitGo, Inc. for Apparent Violations of Multiple Sanctions Programs Related to Digital Currency Transactions (Dec. 30, 2020), available at https://home.treasury.gov/system/files/126/20201230_bitgo.pdf.

[3] See BitGo Announces $16 Billion in Assets Under Custody (December 21, 2020), available at https://www.bitgo.com/newsroom/press-releases/bitgo-announces-16-billion-in-assets-under-custody.

[4] See For a Limited Time BitPay and Simplex Partner to Offer Zero Fees on Crypto Purchases for All of Europe (EEA) (February 15, 2021), available at https://www.businesswire.com/news/home/20210215005244/en/For-a-Limited-Time-BitPay-and-Simplex-Partner-to-Offer-Zero-Fees-on-Crypto-Purchases-for-All-of-Europe-EEA.

[5] U.S. Treasury Department Holds Financial Sector Innovation Policy Roundtable (February 10, 2021), available at https://home.treasury.gov/news/press-releases/jy0023.

The following Gibson Dunn lawyers assisted in preparing this client update: Arthur Long, Judith Alison Lee, Jeffrey Steiner and Rama Douglas.

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, the authors, or any of the following members of the firm’s Financial Institutions, Derivatives, or International Trade practice groups:

Financial Institutions and Derivatives Groups:
Matthew L. Biben – New York (+1 212-351-6300, mbiben@gibsondunn.com)
Michael D. Bopp – Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com)
Stephanie Brooker – Washington, D.C. (+1 202-887-3502, sbrooker@gibsondunn.com)
M. Kendall Day – Washington, D.C. (+1 202-955-8220, kday@gibsondunn.com)
Mylan L. Denerstein – New York (+1 212-351- 3850, mdenerstein@gibsondunn.com)
Michelle M. Kirschner – London (+44 (0) 20 7071 4212, mkirschner@gibsondunn.com)
Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com)
Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com)

International Trade Group:
Judith Alison Lee – Washington, D.C. (+1 202-887-3591, jalee@gibsondunn.com)
Adam M. Smith – Washington, D.C. (+1 202-887-3547, asmith@gibsondunn.com)

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

Now that the first 100 days of the Biden Administration are in full swing, its financial regulatory priorities are becoming clearer. In this Client Alert, we discuss where we expect the Administration to focus, with respect to the banking, fintech, and derivatives sectors.

We believe these to be the principal takeaways:

The Administration’s whole-of-government emphasis on climate change issues should inform the regulatory agencies’ agendas far more than in the past.
The Administration’s focus on racial justice will likely lead to increased enforcement activities, particularly by the Consumer Financial Protection Bureau (CFPB), as well as to a reexamination of the Office of the Comptroller of the Currency’s (OCC) recently revised Community Reinvestment Act (CRA) regulations.
President Biden’s choices to head the OCC, Securities and Exchange Commission (SEC), and Commodity Futures Trading Commission (CFTC) will have significant input into the regulation of digital assets and fintech, with certain Trump-era regulations likely being subject to reexamination.
The CFPB can be expected to return to Obama Administration priorities and enforcement activity, with large financial institutions the likely targets.
The CFTC is likely to increase its aggressive enforcement in the derivatives and commodities markets, as well as maintain a keen focus on climate-related risks in those markets.
At the federal legislative level, Representative Maxine Waters (D-CA) and Senator Sherrod Brown (D-OH), both committee chairs, will likely focus on pandemic relief, inequity in housing, consumer protection, and climate change; in addition, cannabis banking legislation may finally be advanced.
In the immediate future, Congress is focused on the market volatility brought to light by the GameStop short squeeze, including a House Financial Services Committee hearing currently scheduled for February 18th with high-level executives of Robinhood, Citadel, Reddit, and Melvin Capital testifying. The House Financial Services Committee and Senate Banking Committee are also likely to consider legislation to ensure more market stability and possibly regulate order-flow payments.

A. Overarching Administration Priorities: Combatting Climate Change and Advancing Racial Justice

1. Climate Change

Climate change will be a new priority for the financial regulators. At her confirmation hearing, Treasury Secretary Janet Yellen called climate change an “existential threat” and stated that she plans to create a special unit, led by a senior official, to examine the risks that climate change poses to the financial system.[1] It is therefore reasonable to expect that the Financial Stability Oversight Council (FSOC), which Secretary Yellen chairs, will investigate climate-related risks. In December 2020, Senator Dianne Feinstein (D-CA) introduced the Addressing Climate Financial Risk Act, which among other things would establish a permanent FSOC committee to advise the FSOC in producing a report on how to improve the ability of the financial regulatory system to identify and mitigate climate risk.[2] Although Senator Feinstein’s bill will have to be reintroduced this year in the new Congress, Senator Feinstein has called on Secretary Yellen to implement key provisions of the bill via executive action.[3]

In a September 2020 report, titled “Managing Climate Risk in the U.S. Financial System” (the “Report”), the CFTC’s Climate-Related Market Risk Subcommittee of the Market Risk Advisory Committee recommended that the FSOC incorporate climate-related financial risks into its existing oversight function.[4] The Report makes the following policy recommendations:

Congress should establish a price on carbon through legislation; this would be the single most important step to manage climate risk and drive an appropriate allocation of capital.
Financial regulators should actively promote, and in some cases require, better understanding, quantification, disclosure, and management of climate-related risks by financial institutions and other market participants.
Financial regulators should undertake and assist financial institutions to undertake their own pilot climate-risks stress testing.
International collaboration and harmonization should be sought, and indeed, are critical for success in this area.

The Federal Reserve too has started to focus on climate issues. It created a Supervision Climate Committee, a system-wide group meant to build out the Federal Reserve’s capacity to understand the potential implications of climate change for financial institutions, infrastructure, and the markets.[5] In addition, the Federal Reserve is continuing its engagement with the Basel Committee on Banking Supervision’s Task Force on Climate-Related Financial Risks to develop recommendations for effective supervisory practices to mitigate climate-related financial risks, and has started to incorporate climate analysis into its Financial Stability Report and Supervision and Regulation Report.[6] And in December, the Federal Reserve became a full member of the Network for Greening the Financial System, a group of central banks and supervisors working to define and promote green finance best practices.[7] In addition, just this month, a paper published by the Federal Reserve Bank of San Francisco noted that the Federal Reserve has begun incorporating the impacts of global warming into its regulations, including by using climate stress tests and climate scenario analysis to measure banks’ vulnerability to climate-related losses.[8]

2. Advancing Racial Justice

The financial regulatory agency most likely to take the lead on racial justice issues is the CFPB. Acting CFPB Director Dave Uejio recently wrote that, in addition to pandemic-related relief, racial equity was his top priority, and that fair lending enforcement would be a major part of this focus.[9] On February 4^th, Acting Director Uejio stated that he was asking the CFPB’s Division of Research, Markets, and Regulations to

prepare an analysis on housing insecurity, including mortgage foreclosures, mobile home repossessions, and landlord-tenant evictions;
prepare an analysis of the most pressing consumer finance barriers to racial equity to inform research and rulemaking priorities;
explicitly include in policy proposals the racial equity impact of the policy intervention;
resume data collections paused at the beginning of the pandemic, including HMDA quarterly reporting and the CARD Act data collection, as well as the previously completed 1071 data collection and the ongoing PACE data collection;

focus the mortgage servicing rulemaking on pandemic response to avert, to the extent possible, a foreclosure crisis when the COVID-19 forbearances end in March and April; and
explore options for preserving the status quo with respect to Qualified Mortgage and debt collection rules.[10]

Through such actions, the Biden CFPB would join in the efforts of certain states that have made strides in fair lending regulation, passing legislation to regulate more strictly student loan servicers[11] and to mandate small business truth-in-lending disclosures.[12] One should also expect the CFPB to investigate algorithmic models used in credit underwriting as to whether those models disparately impact minority borrowers.

The CRA will be another focus. In May 2020, under Acting Comptroller Brooks, the OCC finalized a substantial change to its CRA regulations, which community groups severely criticized.[13] The Federal Reserve and Federal Deposit Insurance Corporation declined to join the OCC’s action, and in October 2020, the Federal Reserve published an Advanced Notice of Proposed Rulemaking to solicit input regarding modernizing its CRA regulatory and supervisory framework, taking a different approach from the OCC’s.[14] We expect that a Biden-appointed Comptroller of the Currency is likely to revisit Acting Comptroller Brooks’ revisions.

B. Other Expected Priorities

1. Digital Assets and Cryptocurrencies

How President Biden staffs the heads of three regulatory agencies – the SEC, OCC and CFTC – may have significant effects on the regulation of digital assets and cryptocurrencies.[15] Gary Gensler, nominated to head the SEC and the former Chair of the CFTC, is now a Senior Faculty Advisor to the Digital Currency Initiative at MIT’s Sloan School of Management, where he teaches classes on blockchain technology and digital currencies.[16] Michael Barr, a Treasury official in both the Clinton and Obama Administrations, has been identified as a leading candidate to head the OCC; Mr. Barr has served as an advisor to Ripple, on Lending Club’s board, and on the fintech advisory council for the Bill and Melinda Gates Foundation.[17] And Chris Brummer, a Georgetown Law professor who was twice nominated as a CFTC Commissioner in the Obama Administration, has been mentioned as a potential CFTC Chair; when at Georgetown Law, he founded DC Fintech Week.[18]

Each of these agencies will have important digital asset and cryptocurrency issues on its agenda. Just at the end of the Trump Administration, the SEC brought an enforcement action against Ripple Labs Inc. and two of its executives on the grounds that the sale of Ripple’s digital asset, XRP, was an unregistered securities offering under the federal securities laws.[19] A Gensler-led SEC will need to decide whether to continue this action, whether to provide guidance on which digital tokens are securities, and whether digital asset exchanges have to register as national securities exchanges or alternative trading systems.[20] Although Mr. Gensler has espoused openness to helping digital assets and cryptocurrencies reach their “real potential in the world of finance,” even if doing so requires “tailor[ing] some of th[e] rules and regulations” to their ecosystem, he has also taken the view that “100 to 200” exchanges “are basically operating outside of U.S. law.”[21]

A second issue that the Gensler-led SEC will need to address is custody. During the Trump Administration, the SEC issued a statement and requested comments regarding the application of the Customer Protection Rule (Rule 15c3-3) to cryptocurrencies and other digital assets. Similar to a safe-harbor provision, the statement essentially maps a path for specialized broker-dealers to operate for five years without fear of an enforcement action in this area where they maintain physical possession or control of digital asset securities.[22] With the request for comment, however, the SEC suggests that it is looking to establish permanent rules in this area.

At the end of the Trump Administration, the OCC moved to the forefront of cryptocurrency regulation by approving the charter conversion application of Anchorage Trust Company.[23] A second charter conversion application was approved just last week, for Protego Trust Company.[24] Whether the OCC will continue to stake out this leadership position under a new Comptroller is therefore a significant question. On these issues, the fact that there has been controversy about who the new Comptroller will in fact be – progressives have been pushing President Biden to name Professor Mehrsa Baradaran, in part because of her skepticism about fintech, rather than Michael Barr – makes it more difficult to offer definitive predictions.

The CFTC, moreover, remains an important regulator in the area. It has jurisdiction over futures and other derivatives contracts on cryptocurrencies, which continue to be developed, and it also has jurisdiction over manipulation in the spot markets for cryptocurrencies that are not securities (e.g., bitcoin and ether) if such manipulation affects a CFTC-regulated futures market. Given the recent significant volatility and meteoric rise in prices in Bitcoin and other cryptocurrencies, the CFTC’s aggressiveness in exercising its legal authority in these areas could have substantial effects.

2. Fintech: The OCC and Trump Administration Rulemakings

Before leaving government service, Trump Acting Comptroller of the Currency Brian Brooks oversaw several important actions of particular relevance to fintech companies.

The first relates to the so-called “Special Purpose National Bank Charter” for financial technology companies, which was first announced by Obama Administration Comptroller of the Currency Thomas Curry in late 2016.[25] The New York State Department of Financial Services (NYDFS) reacted to this development by suing the OCC, arguing that the OCC did not have the authority under the National Bank Act to grant such charters. A district judge in the United States District Court for the Southern District of New York agreed with NYDFS,[26] and this case is on appeal to the Second Circuit Court of Appeals.[27] In November 2020, the OCC accepted a charter application by the fintech Figure Technologies, Inc. and was shortly thereafter sued again – this time by the Conference of State Bank Supervisors Inc. (CSBS) in federal district court in Washington, DC.[28] The new Comptroller will have to determine whether to press ahead with – and defend in court – the “Special Purpose National Bank” and other non-traditional charters.

The other significant actions taken by the OCC under Acting Comptroller Brooks were two rules passed in response to the 2015 Second Circuit decision, Madden v. Midland Funding LLC.[29] Madden limited the application of National Bank Act preemption of state usury laws in the case of nonbanks that purchase debt originated by a national bank.[30] For many fintechs and other nonbank lenders that partner with loan-originating banks, the Madden decision increased uncertainty as to whether nonbanks become subject to state interest rate caps upon purchasing a loan that, at the time of origination, was not subject to the same requirements. In 2020, the OCC issued the “valid-when-made” rule, which took the position that “interest permissible before [a loan] transfer continues to be permissible after the transfer,”[31] and the “true lender” rule, which stated that a national bank is the “true lender” for a loan if the national bank is either named as such on the loan documents or funds the loan.[32]

As in the case of the “Special Purpose National Bank” charter, certain states challenged the rules in federal court.[33] The states argued that the OCC exceeded its statutory authority in issuing the rules and also focused on the rules’ effects on the states’ authority to regulate interest rates and enforce consumer protection laws more broadly, claiming that the rules are “contrary to Congressional actions to rein in the OCC’s ability to preempt state consumer protection laws.”[34] Briefing is underway on cross-motions for summary judgment regarding the “valid-when-made” rule, and a hearing is calendared for mid-March.[35] With the proceedings regarding the true lender rule only a few months behind, these two cases may provide early indications about the new Comptroller’s priorities.

3. An Invigorated CFPB

Rohit Chopra, President Biden’s appointee for the CFPB Director, served in the Obama Administration as the CFPB’s expert on the student loan industry; he also served as a Democratic FTC Commissioner during the Trump Presidency. If confirmed, his appointment suggests that the CFPB will become a more active enforcement agency, as was the case in the Obama Administration. Mr. Chopra’s public statements while FTC Commissioner have encompassed the following important themes: (i) a focus of enforcement efforts on larger firms rather than small businesses; (ii) targeting firms that facilitate and profit from the largest frauds; (iii) shifting from one-off enforcement actions to systemic enforcement efforts; (iv) making greater use of rulemaking, including by codifying enforcement policy; and (v) co-operating with state attorneys general in the enforcement process.[36] The CFPB may also be expected – like the OCC as described above – to revisit certain Trump-era rulemakings, such as its rulemakings on payday lending, qualified mortgages, and debt collection.

4. Shifting Priorities and Continuing Enforcement at the CFTC

Like the SEC, the CFTC will become a majority-Democratic Commission. It is possible that a new CFTC may seek to revisit some of the rules that were finalized on party-line votes under the Trump Administration. For example, in July 2020, the CFTC approved, by a 3-2 party line vote, a final rule addressing cross-border application of the swap dealer and major swap participant registration requirements.[37] In dissent, Commissioner Rostin Behnam criticized the final rule as “refusing to appropriately retain jurisdiction . . . over transactions that are arranged, negotiated or executed in the United States by non-U.S. [swap dealers].”[38] Commissioner Dan Berkovitz critiqued the final rule for “par[ing] back . . . extraterritorial application” of the Commodity Exchange Act (CEA) and setting “a weak and vague standard” for substituted compliance under a “comparable” regulatory regime.[39] Although Professor Brummer, a contender to lead the CFTC, has written extensively about the role of supervisory cooperation and coordination among international regulators,[40] he has also emphasized that the U.S. should “lead by example” and first “commit to the highest standards” before partnering with regulators abroad “who are like-minded,” indicating that he too would support a stronger cross-border rule.[41]

A changed CFTC is likely to result in increased enforcement and collaboration between the CFTC and other agencies, like the Department of Justice. For instance, in October 2020, the DOJ and the CFTC brought related actions against BitMEX based on allegations that BitMEX illegally operated a cryptocurrency derivatives trading platform and violated the anti-money laundering provisions of the Bank Secrecy Act.[42] In December 2020, the CFTC announced a settlement with Vitol, Inc., marking the CFTC’s first public action coming out of its initiative to pursue violations of the CEA involving foreign corruption.[43] The CFTC worked with the Department of Justice and the United States Attorney’s Office for the Eastern District of New York, which announced a Deferred Prosecution Agreement with Vitol the same day.

C. Congressional Priorities

With a Democratic majority in both houses of Congress, legislative priorities will be shaped by the two relevant Committee chairs, Maxine Waters (D-CA) and Sherrod Brown (D-OH).

In December 2020, Representative Waters sent President Biden a public letter with recommendations on areas where she thinks immediate action should be taken.[44] These include:

Promoting stable and affordable housing;
Increasing CFPB enforcement of consumer financial protection laws;
Restoring and enhancing regulatory safeguards on the financial system, including reversing rules that eased prudential requirements for large banks and strengthening the capital regulatory framework;
Addressing discriminatory lending issues; and
Focusing on climate risks, particularly in the insurance sector.

The hearings scheduled by the House Financial Services Committee also provide insight into what issues the committee believes are the most pressing, including the need for additional pandemic relief, particularly for small and minority-owned businesses, climate change, and lending discrimination. Given recent events, the Committee has also scheduled hearings on the recent market volatility involving GameStop and domestic terrorist financing.[45]

In the Senate, Sherrod Brown (D-OH), the chairman of the Senate Banking Committee, is likely to take a more aggressive stance toward the financial services industry than his predecessor, Senator Mike Crapo (R-ID). Senator Brown is known as one of Congress’s fiercest critics of Wall Street, and plans to reorient the focus of the Banking Committee on addressing the fallout of the pandemic and climate change, and strengthening regulations.[46] Senator Brown’s focus in the immediate future is extending protections from eviction, and affordable housing and housing access will continue to be a priority for the committee.[47] Senator Brown is also keen on a public-banking option and caps on interests rates for payday loans, and has said he intends to investigate the relationship among stock prices, executive compensation, and workers’ wages.[48]

A final area of potential legislative action is cannabis banking. In Congress, the SAFE Banking Act, a bill that would enable banks to offer financial services to legitimate marijuana- and hemp-related businesses, could be re-introduced. Because cannabis remains classified as a Schedule I controlled substance, most financial institutions refrain from providing services to legal cannabis businesses out of fear of adverse regulatory and supervisory action and federal forfeiture based on racketeering or trafficking charges. The SAFE Banking Act would prohibit such regulatory actions and shield banks from liability premised solely on the provision of financial services to a marijuana- or hemp-related business. The SAFE Banking Act passed the House with bipartisan support in 2019, and was originally included in the Heroes Act, passed by the House in May 2020 in response to the COVID-19 pandemic. However, the bill was dropped from the COVID relief measures ultimately enacted in December 2020, and the bill has not come up for a vote yet in the Senate despite some bipartisan support.

______________________

[1] Zachary Warmbrodt, Yellen vows to set up Treasury team to focus on climate, in victory for advocates, Politico (Jan. 19, 2021), https://www.politico.com/news/2021/01/19/yellen-treasury-department-climate-change-460408.

[2] Senator Dianne Feinstein, Press Releases, Feinstein Introduces Bill to Minimize Climate Change Risk in Financial System (Dec. 17, 2020), https://www.feinstein.senate.gov/public/index.cfm/press-releases?ID=27A04819-E44D-435C-AB06-FBC9D6051EB2.

[3] Senator Dianne Feinstein, Press Releases, Feinstein to Secretary Yellen: Use Financial System to Mitigate Climate Change Risk (Jan. 28, 2021), https://www.feinstein.senate.gov/public/index.cfm/press-releases?id=F494CF21-B927-404B-876A-CF80D3231985.

[4] U.S. Commodity Futures Trading Commission Climate-Related Market Risk Subcommittee, Managing Climate Risk in the U.S. Financial System (2020), available at https://www.cftc.gov/sites/default/files/2020-09/
9-9-20%20Report%20of%20the%20Subcommittee%20on%20Climate-Related%20Market%20
Risk%20-%20Managing%20Climate%20Risk%20in%20
the%20U.S.%20Financial%20System%20for%20posting.pdf.

[5] Fed. Reserve Bank of N.Y., Press Release, Kevin Stiroh to Step Down as Head of New York Fed Supervision to Assume New System Leadership Role at Board of Governors on Climate (Jan. 25, 2021), https://www.newyorkfed.org/newsevents/news/aboutthefed/2021/20210125.

[6] Lael Brainerd, Strengthening the Financial System to Meet the Challenge of Climate Change (Dec. 18, 2020), available at https://www.federalreserve.gov/newsevents/speech/brainard20201218a.htm.

[7] See Central Banks and Supervisors Network for Greening the Financial System, https://www.ngfs.net/en.

[8] Glenn D. Rudebusch, FRBSF Economic Letter, Climate Change Is a Source of Financial Risk, Fed. Reserve Bank of S.F. (Feb. 8, 2021), https://www.frbsf.org/economic-research/publications/economic-letter/2021/february/climate-change-is-source-of-financial-risk/.

[9] Dave Uejio, The Bureau is taking much-needed action to protect consumers, particularly the most economically vulnerable (Jan. 28, 2021), https://www.consumerfinance.gov/about-us/blog/the-bureau-is-taking-much-needed-action-to-protect-consumers-particularly-the-most-economically-vulnerable/.

[10] Dave Uejio, The Bureau is working hard to address housing insecurity, promote racial equity, and protect small businesses’ access to credit (February 4, 2021), https://www.consumerfinance.gov/about-us/blog/the-bureau-is-working-hard-to-address-housing-insecurity-promote-racial-equity-and-protect-small-businesses-access-to-credit/.

[11] See, e.g., Jeremy Sairsingh, State Regulation of Student Loan Servicing Continues to Evolve, Am. Bar Assoc. (July 13, 2020), https://www.americanbar.org/groups/business_law/
publications/committee_newsletters/consumer/2020/202007/state-regulation/.

[12] See, e.g., Dafina Williams, Policies to Require Transparency in Small Business Lending Gain Momentum, Opportunity Fin. Network (Oct. 14, 2020), https://ofn.org/articles/policies-require-transparency-small-business-lending-gain-momentum.

[13] See, e.g., Nat’l Cmty. Reinvestment Coal., et al., Joint Statement on CRA Rule Changes from OCC (May 21, 2020), https://ncrc.org/joint-statement-on-cra-rule-changes-from-occ/.

[14] Community Reinvestment Act, 12 C.F.R. 228 (proposed Oct. 19, 2020).

[15] Ephrat Livni, What’s Next for Crypto Regulation, N.Y. Times (Jan. 30, 2021), https://www.nytimes.com/2021/01/30/business/dealbook/crypto-regulation-blockchain.html.

[16] See Gary Gensler Faculty Advisor Profile, available at https://dci.mit.edu/team.

[17] John Adams, Biden’s OCC expected to chart new course for fintechs, crypto, AML, Am. Banker (Jan. 27, 2021), https://www.americanbanker.com/news/bidens-occ-expected-to-chart-new-course-for-fintechs-crypto-aml.

[18] See About DC Fintech Week, available at https://www.dcfintechweek.org/; Chris Brummer, Faculty Profile, https://www.law.georgetown.edu/faculty/chris-brummer/.

[19] Complaint, SEC v. Ripple Labs, Inc., No. 1:20-cv-10832 (S.D.N.Y. Dec. 22, 2020).

[20] Although the SEC brought its first enforcement action for operating an unregistered exchange in 2018, and has brought at least one other such action, these matters have not been as significant as the Ripple action. See SEC, Press Release, SEC Charges EtherDelta Founder with Operating an Unregistered Exchange (Nov. 8, 2018), https://www.sec.gov/news/press-release/2018-258; SEC, Press Release, SEC Charges Dallas Company and its Founders with Defrauding Investors in Unregistered Offering and Operating Unregistered Digital Asset Exchange (Aug. 29, 2019), https://www.sec.gov/news/press-release/2019-164. For additional discussion of crypto securities registration cases, see our bi-annual Securities Enforcement updates, available here.

[21] Annalieae Milano, Everything Ex-CFTC Chair Gary Gensler Said About Cryptos Being Securities, Coindesk (Apr. 24, 2018), https://www.coindesk.com/ex-cftc-chair-gary-gensler-on-tokens-securities-and-the-sec.

[22] SEC, Press Release, SEC Issues Statement and Requests Comment Regarding the Custody of Digital Asset Securities by Special Purpose Broker-Dealers (Dec. 23, 2020), https://www.sec.gov/news/press-release/2020-340.

[23] OCC, News Release 2021-6, OCC Conditionally Approves Conversion of anchorage Digital Bank (Jan. 13, 2021), https://www.occ.gov/news-issuances/news-releases/2021/nr-occ-2021-6.html.

[24] OCC, News Release 2021-19, OCC Conditionally Approves Conversion of Protego Trust Bank (Feb. 5, 2021), https://www.occ.gov/news-issuances/news-releases/2021/nr-occ-2021-19.html.

[25] OCC, Exploring Special Purpose National Bank Charters for Fintech Companies (Dec. 2016), https://www.occ.gov/publications-and-resources/publications/banker-education/files/pub-special-purpose-nat-bank-charters-fintech.pdf.

[26] Vullo v. Office of Comptroller of Currency, 378 F. Supp. 3d 271, 292 (S.D.N.Y. 2019) (finding that “the term ‘business of banking,’ as used in the [National Bank Act], unambiguously requires receiving deposits as an aspect of the business”); Lacewell v. Office of the Comptroller of the Currency, 2019 WL 6334895, at * 1–2 (S.D.N.Y. Oct. 21, 2019) (prohibiting the OCC from issuing charter to non-depository fintech applicants).

[27] See Lacewell v. Office of the Comptroller of the Currency, No. 19-4271 (2d Cir. Dec. 16, 2020), ECF No. 108.

[28] Complaint at ¶¶ 1, 3, Conference of State Bank Supervisors v. Office of the Comptroller of the Currency, No. 20-cv-3797 (D.D.C. Dec. 22, 2020).

[29] See generally Madden v. Midland Funding, LLC, 786 F.3d 246 (2d Cir. 2015).

[30] Id. at 250–51.

[31] Permissible Interest on Loans That Are Sold, Assigned, or Otherwise Transferred, 85 Fed. Reg. 33,530 (June 2, 2020) (to be codified at 12 CFR Parts 7 and 160).

[32] National Banks and Federal Savings Associations as Lenders, 85 FR 68742 (Oct. 30, 2020) (to be codified at 12 CFR Part 7).

[33] See Sylvan Lane, Seven states sue regulator over ‘true lender’ rule on interest rates, The Hill (Jan. 5, 2021), https://thehill.com/policy/finance/532759-seven-states-sue-regulator-over-true-lender-rule-on-interest-rates?rl=1.

[34] Complaint at ¶¶ 11–12, People of the State of New York v. Office of the Comptroller of the Currency, No. 21-cv-00057 (S.D.N.Y Jan. 5, 2021) (challenging “true lender” rule); accord Complaint at ¶¶ 7–9, People of the State of California v. Office of the Comptroller of the Currency, No. 20-cv-05200 (N.D. Cal., July 29, 2020) (challenging valid-when-made rule).

[35] Order Granting As Modified Joint Stipulation, No. 20-cv-05200 (N.D. Cal. Oct. 5, 2020) (setting briefing schedule).

[36] See https://www.ftc.gov/about-ftc/biographies/rohit-chopra/speeches-articles-testimonies.

[37] CFTC, Press Release, CFTC Approves Final Cross-Border Swaps Rule and an Exempt SEF Amendment Order at July 23 Open Meeting (July 23, 2020), https://www.cftc.gov/PressRoom/PressReleases/8211-20.

[38] Public Statement, Dissenting Statement of Commissioner Rostin Behnam Regarding the Cross-Border Application of the Registration Thresholds and Certain Requirements Applicable to SDs and MSPs – Final Rule (July 23, 2020), https://www.cftc.gov/PressRoom/SpeechesTestimony/behnamstatement072320

[39] Public Statement, Dissenting Statement of Commissioner Dan M. Berkovitz on the Final Rule for Cross-Border Swap Activity of Swap Dealers and Major Swap Participants (July 23, 2020), https://www.cftc.gov/PressRoom/SpeechesTestimony/berkovitzstatement072320 (quoting Kadhim Shubber, US regulator investigates oil fund disclosures, Fin. Times (July 15, 2020), available at https://www.ft.com/content/1e689137-2d1f-4393-a18f-fe0da02141cc.)

[40] See, e.g., Limiting the Extraterritorial Impact of Title VII of the Dodd-Frank Act: Before the House Financial Services Committee, 112th Cong. (2012) (Written Testimony of Chris Brummer, Professor of Law, Georgetown University Law Center), https://financialservices.house.gov/uploadedfiles/hhrg-112-ba-wstate-cbrummer-20120208.pdf.

[41] Nominations of Christopher James Brummer and Brian D. Quintenz to be Commissioners of the Commodity Futures Trading Commission: Hearing before the Committee on Agriculture, Nutrition, and Forestry, 114th Cong. (2016) (testimony by Christopher James Brummer, Nominee), https://www.congress.gov/114/chrg/shrg23593/CHRG-114shrg23593.htm.

[42] CFTC, Press Release, CFTC Charges BitMEX Owners with Illegally Operating a Cryptocurrency Derivatives Trading Platform and Anti-Money Laundering Violations (Oct. 1, 2020), https://www.cftc.gov/PressRoom/PressReleases/8270-20.

[43] Gibson Dunn, What the CFTC’s Settlement with Vitol Inc. Portends about Enforcement Trends (Jan. 20, 2021) https://www.gibsondunn.com/what-the-cftcs-settlement-with-vitol-inc-portends-about-enforcement-trends/; see also CFTC, Press Release, CFTC Orders Vitol Inc. to Pay $95.7 Million for Corruption-Based Fraud and Attempted Manipulation (Dec. 3, 2020), https://www.cftc.gov/PressRoom/PressReleases/8326-20.

[44] Letter from Rep. Maxine Waters, Chairwoman, U.S. House of Representatives Committee on Financial Services, to President-elect Joseph Biden (Dec. 4, 2020), available at https://financialservices.house.gov/uploadedfiles/120420_cmw_ltr_to_biden.pdf.

[45] U.S. House Comm. On Fin. Servs., Press Releases, Waters Announces February Hearing Schedule (Feb. 1, 2021), https://financialservices.house.gov/news/documentsingle.aspx?DocumentID=407103.

[46] See, e.g., Zachary Warmbrodt, Wall Street scourge Sherrod Brown to get ‘gigantic megaphone’ as Senate Banking chair, Politico (Jan. 11, 2021), https://www.politico.com/news/2021/01/11/sherrod-brown-senate-banking-chair-457692.

[47] Sylvan Lane, Brown puts housing, eviction protections at top of Banking panel agenda, The Hill (Jan. 12, 2021), https://thehill.com/policy/finance/533911-brown-puts-housing-eviction-protections-at-top-of-banking-panel-agenda.

[48] Emily Flitter, Next Senate Banking Chairman Sets Lowe-Income and Climate Priorities, N.Y. Times (Jan. 12, 2021), https://www.nytimes.com/2021/01/12/business/banking-environment-housing-democrats-sherrod-brown.html.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Financial Institutions or Derivatives practice groups, or the following authors:

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A. Key Themes

1. Concern with Size and Interconnectedness

2. Private Versus Public Interest

3. Preference for Narrow Banking

4. Innovation as a Source of Risk

5. The Futility of Bank Supervision

B. Consequences For Regulatory Priorities

1. Size and Interconnectedness

2. Private Interest Versus Public Interest

3. Narrow Banking

4. Innovation and Fintechs

5. The Quarles/Brainard Divide – Likely Positioning

I. Filing and Settlement Trends

A. Filing Trends

B. Industry and Other Trends in Cases Filed

C. Settlement Trends

II. What to Watch for in the Supreme Court

A. Supreme Court Issues Narrow Decision in Price-Impact Case

B. Supreme Court to Decide whether the PSLRA’s Discovery Stay Applies in State Court

C. The Court Addresses Constitutional Challenges to Administrative Adjudicators

III. Delaware Developments

A. Court of Chancery Invalidates Poison Pill under Second Unocal Prong

B. Court of Chancery Rejects Claim that Pandemic Constituted a Materially Adverse Effect

C. Bellwether SPAC Litigation Remains in Initial Stages

D. Court of Chancery Determines CEO Breached Fiduciary Duty and Financial Advisor Aided and Abetted That Breach in Course of Executing a Merger

E. Appraisal Litigation Continues Its Steady Decline

IV. Further Development of Disseminator Liability Theory Upheld in Lorenzo

V. Survey of Coronavirus-Related Securities Litigation

A. Securities Class Actions

1. False Claims Concerning Commitment to Safety

2. Failure to Disclose Specific Risks

3. Alleged Insider Trading and “Pump and Dump” Schemes

B. Stockholder Derivative Actions

1. Disclosure Liability

2. Oversight Liability

3. Insider Trading

C. SEC Cases

VI. Falsity of Opinions – Omnicare Update

VII. Halliburton II Market Efficiency and “Price Impact” Cases

VIII. Other Notable Developments

A. Morrison Domestic Transaction Test

B. Eighth Circuit Strikes Class Allegations under Rule 12(f)

C. Congress Codifies SEC Disgorgement Remedy

D. Delaware Exclusive Forum Bylaws Applicable to Section 14

E. Ninth Circuit Upholds Broad Protection for Forward-Looking Statements

I. Background

A. What are NFTs and What is the Blockchain?

B. What Do You Get When You Buy An NFT?

II. Intellectual Property

III. Profit Participations

IV. Securities Law

V. Climate Change

VI. Conclusion

I. OFAC’s Enforcement Against BitGo

II. OFAC’s Enforcement Against BitPay

III. Conclusion

A. Overarching Administration Priorities: Combatting Climate Change and Advancing Racial Justice

1. Climate Change

2. Advancing Racial Justice

1. Digital Assets and Cryptocurrencies

2. Fintech: The OCC and Trump Administration Rulemakings

3. An Invigorated CFPB

4. Shifting Priorities and Continuing Enforcement at the CFTC

C. Congressional Priorities

**A. Court of Chancery Invalidates Poison Pill under Second Unocal Prong**