Together, these new laws create an uneven regulatory patchwork that has already resulted in the divestment of billions of dollars in state funds from investment managers. Investors and businesses increasingly face a choice between complying with these new state laws and achieving the ESG goals promised to investors and stakeholders. New laws introduced in 2023 expand the scope of anti-ESG laws and present significant uncertainty for an increasing range of businesses.

Fiduciary duties & non-pecuniary factors

Federal regulators and conservative lawmakers in some states are taking opposing approaches to defining the duties of fiduciaries. Investors making decisions using ESG frameworks include factors such as greenhouse gas emissions, which go beyond traditional fiduciary criteria like return on investment. The conflict reflects a philosophical disagreement between the belief that companies should work only to maximize returns, on one hand, and consideration of the interests of a wider range of stakeholders and outcomes, on the other.

In 2022, the U.S. Department of Labor (DOL) released a final rule addressing when fiduciaries may consider ESG factors in accordance with their fiduciary duties under the Employment Retirement Income Security Act of 1974 (ERISA). Under ERISA, retirement plan fiduciaries have a duty to act solely in the interest of plan participants and beneficiaries. The new rule clarifies that fiduciaries may consider ESG factors such as climate change and may select from competing investments based on collateral economic or social benefits. In late-January, 25 states filed a lawsuit in federal court seeking an injunction against the new rules.

Even before the release of the DOL final rule, several states proposed laws prohibiting the use so-called “non-pecuniary factors” in making investment decisions for state pensions and other funds. Earlier in 2022, the American Legislative Exchange Council introduced the State Government Employee Retirement Protection Act, model legislation that closely mirrors fiduciary duty bills later introduced in several states.

On March 24, Kentucky Governor Andy Beshear (D) signed House Bill 236 into law. Under the statute, “environmental, social, political, or ideological interests” not connected to investment returns may not be included in determining whether a fiduciary or proxy of the state retirement system is acting solely in the interest of the members and beneficiaries. Five non-exclusive factors, including statements of principles and participation in initiatives, are listed as evidence a fiduciary has considered or acted on a non-pecuniary interest.

In 2023, legislators introduced fiduciary duty laws of varying scope in several large states, including Ohio and Missouri. In total, legislators in more than 20 states have introduced bills amending the fiduciary duty laws covering investing and proxy voting for state retirement systems.

To further complicate matters, state pension funds in states like New York and California take the opposite approach, setting net zero carbon targets for their portfolios, for example.

ESG as boycott

Conservative politicians often claim ESG uses economic power to enact political agendas through alternative means. They argue goals like decarbonization amount to a boycott of fossil fuel companies and are a threat to the economies of states dependent on the extractive industry. New legislation expands on previous anti-boycott laws to include targeting companies that consider ESG factors.

Several states have already started the process of divesting retirement system and other funds from financial companies they claim boycott fossil fuel companies. For example, a 2021 Texas law requires the State Comptroller to publish a list of boycotting companies. The Comptroller’s initial criteria for inclusion included membership in Climate Action 100 and the Net Zero Banking Alliance/Net Zero Asset Managers Initiative, two major financial industry initiatives focused on climate change.

Utah Governor Spencer Cox (R) signed a bill into law on March 15 that goes beyond state investments to prohibit companies from coordinating or conspiring with another company to eliminate viable options for another company to obtain a product or service “with the specific intent of destroying a boycotted company.” A boycotted company is defined by the law as one that engages in aspects of the firearms industry or does not meet certain ESG standards.

Social Credit scores

Speaking in support of the Utah anti-conspiracy bill, state Rep. Mike Petersen (R) said: “I’m convinced that ESG is not a conspiracy theory, it is a conspiracy truth.” To many of its opponents and skeptics, ESG is an unaccountable shadow regulatory system that takes specific aim at industries and policies supported by conservatives.

The belief that the stated goals of ESG mask other motives is at the source of bills introduced in several states to prohibit financial institutions from using a “social credit score” to make lending or other decisions and defining the term to include ESG. The language invokes the Social Credit System in use in China, which monitors and punishes individuals and businesses for certain behaviors and serves as a type of blacklist.

Though some ESG frameworks produce numerical scores for various metrics, the comparison to the Social Credit System is rejected by ESG experts. There is no substantive overlap between China’s surveillance apparatus and ESG in goals or application.

This distinction has not dissuaded lawmakers in Florida, who enacted legislation amending state banking law to make the use of social credit scores by lenders an unsafe and unsound practice in violation of state financial institutions codes and unfair trade practices laws, subject to sanctions and penalties. The law prohibits the use of a social credit score based on factors that include, among other things, ESG standards on topics including emissions and corporate board diversity.

The Florida bill and others like it expand previous efforts by the state to divest state funds to restrict decisions on private lending, potentially involving many more financial institutions.

On the horizon

The volume of anti-ESG bills introduced in state legislatures is growing. Many are passing as the topic gains political salience, particularly on the political right. As these laws pass, they serve as models for similar legislation in other states. However, the success of future legislation faces significant headwinds.

Anti-ESG laws have been passed predominantly in states where Republicans control the governorship and both houses of the legislature. So far, there is little indication many Democrats will support these anti-ESG laws. Indeed, the growing scope of anti-ESG laws pose another roadblock to their widespread adoption. Newer laws impose restrictions on a much broader range of companies, which only increases the complexity of enforcement and increases the risk of a legal challenge.

A lack of uniformity means businesses operating in more than one state may have to make difficult choices. The broader economic consequences of anti-ESG laws are still undetermined, but compliance with these new laws presents immediate challenges.

The regulator’s monitoring of the marketplace in 2022 found 1,882 promotions from unauthorized firms that required amendment or withdrawal following intervention by the agency, an increase of 34% over the 1,410 promotions that received such treatment in 2021. An additional 8,582 promotions from authorized firms were similarly required to be amended or withdrawn, compared with just 573 in 2021, a massive increase of 1,398%.

The FCA notes that “[l]ast year we saw an increase in the use of bloggers and influencers on social media such as Instagram, Facebook, and YouTube, promoting financial products, particularly investment products, to younger age groups. We also saw an ongoing trend in the number of bloggers promoting credit on behalf of unauthorized third parties, with a particular growth in financial promotions targeting students.”

Finfluencers & regulations

The emergence of finfluencers (short for financial influencers) – individuals on social media who advocate a particular type of investment option – is highlighted in the Royal Mint’s 2022 Gen Z Investment Report, which found that 23% of young investors are followers of finfluencers.

… finfluencers need to be aware that social media is not an oasis where consumer protection law, advertising standards and intellectual property rights can be ignored.

Some see the dissemination of financial information via social media platforms as a healthy way of engaging people in investment activity, and they welcome the greater transparency inherent in this mode of communication. However, finfluencers need to be aware that social media is not an oasis where consumer protection law, advertising standards and intellectual property rights can be ignored.

Regulators around the world have begun to issue guidance to both finfluencers and their followers. The 2021 Statement on Investment Recommendations on Social Media by the European Securities and Markets Authority (ESMA), explores the boundaries between providing financial information and providing financial advice and recommendations online. Also, the Securities and Futures Commission of Hong Kong’s Guidelines on Online Distribution and Advisory Platforms stipulates that any licensed financial adviser will be held accountable through all channels, including social media. The New Zealand Financial Markets Authority has a Guide to Talking about Money Online, providing tips for consumers and finfluencers. Meanwhile, the Australian Securities and Investments Commission has an information sheet for finfluencers who include details of financial products and services in their content.

If finfluencers provide financial advice and recommendations per regulators’ definitions of those terms, they must adhere to regional regulations on authorization and conduct of business. However, the popularity of finfluencers, which is being fueled by shifting attitudes among investors and the more varied range of channels through which they can enter the investment market, makes it difficult for regulators and firms to ensure that customers are being treated fairly.

New attitudes toward investing

Factors such as new technology, the global pandemic and climate change concerns have caused shifts in investors’ attitudes. The Royal Mint report paints a mixed picture of young adults’ investment behavior. On the one hand, social media was found to have caused 17% of those surveyed to adopt a get-rich-quick mentality, with people expecting to double or triple what they had invested within a short space of time.

On the other hand, the report also finds that when losses occurred, 64% of 16- to 25-year-olds actively looked to diversify their risk by adding what they believed were “safer investments” to their portfolios. A total of 80% of that same group now dedicates a portion of their income to investing in their future, with two-fifths stating the pandemic made them realize the value of having secure finances. As a result, more than one-third have taken it upon themselves to learn about investing as a way of helping to grow their money.

A 2021 research report by the FCA highlighted that, for those investing in high-risk products, “the challenge, competition, and novelty are more important than conventional, more functional reasons for investing, like wanting to make their money work harder or save for their retirement.

Case study of a finfluencer

Paul Pierce, a former Boston Celtics pro basketball player and NBA Hall of Famer, promoted EthereumMax (EMAX), a cryptocurrency coin or token, on social media as did many other celebrities. In his tweets, Pierce showed screenshots of alleged profits along with links where followers could make purchases. Pierce is one of many celebrities who made such claims of financial gain using these types of investments. During his promotion of EMAX tokens on Twitter, Pierce failed to disclose that he was paid for his promotion with EMAX tokens worth more than $244,000, the US Securities and Exchange Commission (SEC) alleged.

“This year, we will continue to put the pressure on people using social media to illegally promote investments, which put people’s hard-earned money at risk.”

— Sarah Pritchard  | Executive Director for Markets, Financial Conduct Authority

Pierce has now agreed to pay more than $1.4 million to settle charges he illegally promoted digital assets, the SEC stated in February. This settlement is larger than the $1.26 million paid by Kim Kardashian to settle similar SEC charges related to promoting EMAX. The settlements with Pierce and others mark the latest move by the SEC to crack down on celebrity endorsements of crypto products.

The increase in the number of noncompliant finfluencer promotions suggests that as investors appear more willing to take risks, firms’ marketing departments may be tempted to make financial promotions more exciting.

In the UK, for example, regulations are based on the principle of being clear, fair and not misleading. Regulations also provide detailed requirements for firms about including the need for financial promotions to give a fair and prominent indication of any relevant risks, and to be presented in a way that is likely to be understood by the average member of the group to whom it is directed. Further, these promotions cannot disguise, diminish or obscure important elements, statements or warnings.

The future

This year, there won’t likely be any letup in regulators’ focus on the use of financial promotions. Sarah Pritchard, executive director for markets at the FCA, gave clear indication what the future holds. “This year, we will continue to put the pressure on people using social media to illegally promote investments, which put people’s hard-earned money at risk,” she said.

As the number of tools and resources issued by regulators for monitoring promotions increases, so too does the risk to firms of being caught for noncompliant behavior. The FCA is consulting on the introduction of tougher checks for financial promotions and measures that will remove harmful promotions more quickly.

Finally, firms in the UK need to consider the impact of the new Consumer Duty, which many are due to implement in July 2023. “Under the duty, firms will need to demonstrate that they are providing consumers with information which helps them to make effective and informed decisions about financial products and services,” the FCA stated.

In the US, the SEC is moving to chastise all bad actors, not just celebrities, according to Gurbir S. Grewal, director of the SEC’s Division of Enforcement. “The federal securities laws are clear that any celebrity or other individual who promotes a crypto-asset security must disclose the nature, source and amount of compensation they received in exchange for the promotion,” Grewal said.

As workloads are increasing, there is also a limit on the finite resources available to manage these growing compliance burdens. These concerns are compounded by a diverse and expanding range of subject areas with which compliance officers need to be familiar as well as an expectation of a greater volume of regulatory change. This larger picture is set against increased costs and difficulties in recruiting skilled compliance staff.

Overall, survey respondents outlined a sector that held greater responsibility but also contained practical operational challenges that threaten to undermine efforts to provide their firms with the level of compliance support required in today’s environment.

Thomson Reuters Regulatory Intelligence’s 14th annual survey of compliance leaders — distilled into the 2023 Cost of Compliance Report — was undertaken against this backdrop. The report explores the challenges that compliance officers face in 2023 and exposes the depth of issues that compliance leaders have encountered. The survey was taken of more than 350 practitioners, representing global systemically important banks (G-SIBs), other banks, insurers, asset and wealth managers, regulators, broker-dealers, and payment services providers mainly in the United States, the European Union, and the United Kingdom.

Overall, survey respondents outlined a sector that held greater responsibility but also contained practical operational challenges that threaten to undermine efforts to provide their firms with the level of compliance support required in today’s environment.

Some of the key findings of the annual report include:

• • • The volume of regulatory change was expected to increase and was seen as a key compliance challenge for boards and compliance officers.
    • Cost pressure and balancing competitive and compliance pressures were reported as key challenges, yet 45% of respondents did not monitor their cost of compliance with regulations across their organizations.
    • One-third of respondents expected compliance teams to grow, and the cost of compliance staff was also expected to increase, while turnover of staff and budgets remain at 2022 levels. An increase in the number of firms using outsourced providers for their compliance functionality was also reported.
    • Retaining skilled resources is seen as essential to deliver on a growing range of subjects with which the compliance function is involved. The recruitment of the appropriate talent comes at a cost, and the appeal of becoming a compliance officer has been reduced due to the potential for increased personal liability.
    • Low staff morale is emerging as a key conduct risk for many financial services firms. This may lead to wider noncompliance issues due to staff error or manipulation. Couple this with the identification of cybersecurity as a prominent culture and conduct risk, and it becomes more important for firms to ensure internal security controls are robust.
    • Firms operated an effective compliance culture despite the conduct and culture risks, with respondents predicting they will spend more time on culture and conduct issues in 2023.

The findings of this annual report are intended to help financial services firms with planning and resourcing while allowing them to benchmark their own approaches with those of the wider industry. The experiences of the G-SIBs are analyzed where these can provide a sense of the stance taken by the world’s largest financial services firms.

You can download a full copy of Thomson Reuters Regulatory Intelligence’s 2023 Cost of Compliance Report, here.

In 2022, the significant changes to Section 174 went into effect. Enacted in 1954 as part of the Internal Revenue Code (IRC), Section 174 was created to eliminate uncertainty in tax accounting treatment of research and experimental development (R&E, or more popularly, R&D) expenditures and to simply encourage research and developmental experimentation as to way to grow innovation.

Section 174 allows businesses to either deduct or amortize certain R&D costs. Deductions can be made in the year in which they are paid or incurred, or they can be amortized over a period of not less than 60 months, beginning with the month in which the taxpayer first realizes benefits from the expenditures. Below are five things to know now about the updates to Section 174.

1. Which entities are subjected to Section 174 capitalization?

In short, Section 174 applies to any taxpaying entity that incurs qualifying R&D costs independent of specific industry or business size. Specifically, there are several types of businesses that are impacted, including:

• • • Corporations — Regardless of size, once corporations have incurred qualifying research and development costs;
    • Small businesses including startups — Regardless of current profitability status, small businesses and startups that are heavily invested in R&D may capitalize or amortize their research expenses;
    • Sole proprietorships, partnerships, and LLCs — Also, these entities can take advantage of Section 174 if they have qualifying R&D expenses; and
    • Past-through entities including S-corporations — These too can utilize Section 174 for eligible cost associated with R&D, and the R&D credits can be passed through partners, individual shareholders, or members.

2. What qualifies? What are the kinds of costs subject to Section 174 capitalization?

There are several categories of expenses that can be subject to Section 174 capitalization, including:

• • • Salaries and wages — The salaries and wages of employees who conducting or directly supervising or supporting research activities can be capitalized;
    • Supplies and materials — The cost associated with supplies used in the research process can be capitalized, including anything from lab equipment to the software required for the research;
    • Patent costs — The cost associated with obtaining patents for a product or process developed through research activities can be capitalized;
    • Overhead expenses — There are certain indirect expenses that can be allocated to research activities, including utilities for a research lab or depreciation on research equipment; and
    • Contract research expenses — If a third party is used to conduct the research on a company’s behalf, the cost can be capitalized.

3. What kinds of items are excluded from Section 174 deductions?

Not all R&D expenses can be deducted under Section 174. For example, costs for land or depreciable properties are not deductible. Additionally, costs associated with research conducted after the beginning of commercial production, marketing research, quality control, and funded research (such as research funded by any grant, contract, or otherwise by another person or governmental entity) are generally excluded.

4. What is considered R&D as defined by Section 174?

For tax purposes, the following four-part test from the Internal Revenue Service must be met in order to qualify for R&D credit:

• • • Business purpose — The research must be intended to benefit a business component, which can be any product, process, computer software, technique, formula, or invention that is to be held for sale, lease, license, or use by the company in a trade or business of the company.
    • Technological in nature — The business component’s development must be based on a hard science, such as engineering, physics, chemistry, the life or biological sciences, engineering, or computer sciences.
    • Elimination of uncertainty — The activity must be intended to discover information that would eliminate uncertainty about the development or improve of a product or process.
    • Process of experimentation — The business must evaluate multiple design alternatives or have employed a systematic trial-and-error approach to overcome the technological uncertainty.

5. Which states have conformity to Section 174?

Companies will have to check with the individual state in which they are filling in to determine if that particular state has conformed. States either conform to the IRC Section on a rolling basis or a static basic. A state that conforms on a rolling basis means it will automatically adopt any changes to the federal tax code as those changes occur. Some states that conform on a rolling basis include Illinois, New Jersey, New York, and Pennsylvania.

States that conform on a static basis adopt the federal tax code as of a specific date and do not automatically incorporate subsequent changes. Some static states include Florida, Georgia, Virginia, and North Carolina. There are some states that have selective conformity (this means they adopt selective portions of the IRC), including Arkansas, Colorado, and Oregon.

It is worthwhile to note that levels of conformity can vary by state and may be subject to specific adjustments, additions, or exceptions based on the individual state’s tax laws.

Yet rather than a binary outcome, the global economy actually faces multiple scenarios which could heavily impact global trade, many of which are the result of means meant to actually bypass the debt ceiling and avoid default.

Thus, it’s important to map out the potential impact of the different options so that companies and organizations can both understand the implications of different strategies and prepare for the surprisingly varied outcomes, many of which would still massively impact global trade.

The trillion-dollar coin

One of the most talked about but seemingly comical scenarios involves the minting of a trillion-dollar coin. This possibility utilizes the U.S. Treasury’s relatively uninhibited ability to mint money to generate the funds necessary to continue government spending without increasing the debt.

The issue is that this amounts to little more than turning on the money printer, a measure which has historically caused intense inflation, an economic challenge only starting to come under control. While this would keep the United States from default, inflation would not be the only cost, as confidence in the U.S. government and the dollar would likely take a significant hit. Global financial markets could see a bout of instability due to this decrease in confidence, which may make financing operations more difficult.

This workaround is nothing new, as the temptation for government to print its way out of a debt crisis has been a longstanding fantasy with often dire results. One can think of this as the Ford Pinto scenario, a classically dangerous vehicle rolled out despite far superior options being available.

Premium Treasury bonds

If the trillion-dollar coin scenario is the Ford Pinto, then the strategy of issuing a series of premium Treasury bonds is the Ferrari Daytona: more powerful, more refined, and slightly more likely to get you to your destination uninjured.

This scenario relies on a legal quirk, where the debt ceiling applies only to the face value of outstanding government debt. Here, what the government would do is reissue already outstanding bonds with an additional payment premium, basically promising a higher interest rate in exchange for a burst of upfront cash. This both avoids default by injecting additional revenues into the government’s cash flow and avoids the inflation-fueling effect that minting a trillion dollars would have.

In addition, the savviness of the solution may bolster confidence in the U.S. government’s ability to manage itself, as well as lessen the potential impact of future debt ceiling crises if found to be a workable solution. For global trade, the primary challenge would be the possible mixed market reaction, but the turmoil here would be light.

The primary threat would be the exact opposite of the trillion-dollar coin. Rather than sparking inflation, the premium bonds could result in deflationary pressure. For global trade, deflation in the U.S. could be a greater threat than inflation, sapping consumer spending and creating a myriad of other issues which are relatively exotic and potentially dangerous. Some economic concerns already exist that suggest that the U.S. could go into a deflationary cycle soon, so adding further deflationary pressure could add fuel to this concern.

The sticking point is that this scenario is unlikely given the remaining time before the U.S. hits the default point. Bond programs like this take time to set up and every day closer to default-day the United States approaches, the less likely premium Treasury bonds can be implemented. Depending on how the current conflict resolves, premium bonds may be a more tempting solution in the future.

14^th Amendment Constitutional crisis

The 14^th Amendment of the constitution states that: “The validity of the public debt of the United States… shall not be questioned.”

This gives an opening for president to declare the debt limit itself as unconstitutional and the issue null and void. But this does not mean that the potential impacts of a debt ceiling crisis would be swept away. Rather, they would hang over the heads of the global economy like a sword of Damocles as an inevitable court battle rages though the U.S. legal system.

An unfavorable Supreme Court verdict could plunge the U.S. into default with little warning, throwing the global economy into turmoil and actually making things worse than if the U.S. defaulted on the original date. Simply the heightened uncertainty preceding a verdict could make currency markets unstable and roil other financial markets until the constitutional crisis is resolved. Any instability in such markets will only make global trade more difficult and riskier.

In the long term, if this move were to be upheld, it could potentially strengthen international confidence in the U.S.’s ability to meet its debt obligations and bolster its stability by removing the possibility of another debt ceiling conflict. This would thereby bolster U.S. trade negotiating positions and reinforce its standing as a central hub of global trade.

Non-technical default

As addressed previously, another option available to the Treasury to avoid default in the technical sense is to redirect its remaining cashflow towards paying back debt holders. Think of it like having a pitcher and two glasses: there may not be enough water to fill both glasses, but instead of evenly distributing the liquid, you could instead focus on filling one glass to satisfaction. Doing so with bonds would keep the U.S. from technically defaulting and deter the worst of the consequences.

The issue is that, with more of the cash flow going to bonds, there will be even less to go towards government spending such as social security, pay for government employees/military, and economic programs. The likely result is a deep domestic recession which could spread globally. Yet for global trade, this would resemble a more traditional economic crunch, one already well-explored. Some rearranging of global trade away from the United States and a loss of trade prestige for the dollar would be probable, but not quite to the scale as a full default would have.

Full default

The fallout of a full default is simultaneously well-explored and completely alien, with few available historical examples to guide expectations. What is most likely is global economic distress and financial market chaos as the most risk-free asset in the global market suddenly fails. The shift away from the United States both as an economic hub and the head of the world financial order would be a likely and swift outcome, with a large scale-rearrangement of global trade.

Indeed, the global ramifications would be deep and contagious, likely pulling the rest of the world down with the United States into recession.

A full default is the worst-case scenario, one where winners are defined by those who lose the least. This remains an unlikely outcome, in the same way that a nuclear war is unlikely due to its promise of mutual destruction. In the same way, however, its possibility cannot be ignored.

Negotiated Settlement

The traditional way that the debt ceiling crises has been resolved in the past remains the most likely. Congress and the president will find a negotiated settlement to raise the debt ceiling in exchange for some level of concessions.

For global trade, the only likely result is slightly higher interest rates and some minor movement in the financial world, escalating as negotiations approach the deadline. Fears will fade and the mainline expectations for global trade will reassert themselves as if this never happened in the first place… until it happens all over again.

The remarks, made recently at the Association of Certified Anti-Money Laundering Specialists (ACAMS) conference, are far from surprising, given the flood of targeted sanctions imposed by governments worldwide since Russia’s February 2022 invasion. And the fact that Russian oligarchs have sought to shield their assets and evade sanctions by assigning family members, associates, and others as nominee owners only has added to the work banks must do.

During early examinations, regulators found that banks were struggling to comply with “regional-focused sanctions” imposed by the United States Treasury’s Office of Foreign Assets Control (OFAC), said Lisa Arquette, associate director, anti-money laundering (AML) and cyber fraud branch with the Federal Deposit Insurance Corporation, and speaker at the ACAMS conference. “Those became a little bit more difficult for institutions to implement at the beginning,” Arquette noted. “But I think they’ve worked through that, and OFAC as a partner to financial institutions has done a lot of outreach.”

Arquette explained that it was vital that when there is a change in beneficial ownership of a legal entity customer, banks should “make sure you have a process to identify that person or those people so that they can also be scanned” against sanctions lists. “There are lots of moving parts related to a lot of commercial entities and legal entities — intentionally — and it’s difficult to know who to add to the scanning process to make sure that you’re not processing transactions that should be blocked or rejected.” she said.

“Malicious actors, threat actors, intentionally may change that information, which is why your diligence is so critically important.”

Stretching ‘finite resources’

As the deluge of Russia sanctions came in wave after wave, banks with “finite resources” needed to devote “an incredible amount of time and energy [to] sanctions compliance,” said speaker Koko Ives, manager, Bank Secrecy Act AML compliance section in the Division of Supervision and Regulation at the Federal Reserve Board. “The pace, the number, the complexity, of Russia sanctions was really unprecedented,” Ives said.

“The global response with E.U., U.S. and U.K. coordination but not identical sanctions, made it particularly difficult for globally operated institutions to navigate all those sanctions, and that was done well,” Ives said. “I guess their existing sanctions programs were pretty strong because that was surprisingly well done in an incredibly time-intensive and difficult [environment].”

The Fed is examining “with the same frequency as before” and “nothing has changed with our examination process,” she added. “Any sort of [bank compliance] issues are garden variety… related to not being able to update software for [sanctions lists] timely enough so there might be something that slips through, or misunderstanding of [OFAC] general licenses, that kind of thing that causes compliance issues.”

Most banks have done ‘really good job’

Another speaker, Donna Murphy, deputy comptroller for compliance risk with the Office of the Comptroller of the Currency (OCC), said she “would echo” what Arquette and Ives said and added that “institutions spent a tremendous amount of resources dealing with those very fast-moving and complex sanctions programs, and in general did a really good job.

“Where we’ve seen issues is where the sanctions programs were not dynamic enough and sometimes maybe didn’t have the capability — at least initially, and it had to be built — to deal with targeted, regional sanctions as opposed to country sanctions, or the complex and evolving structures of some of the sanctioned entities,” Murphy said.

Changes in beneficial ownership or control of legal entities “are very difficult to keep up with as sanctions are evolving and the entities are evolving,” she explained. “It is challenging and needs a lot of focus. I think in general the institutions have done a very good job of implementing these really critical programs for our national security.”

Murphy said the OCC has “spent a lot of time focusing on providing as many resources as possible to our examiners.”

She noted that sanctions have not always been a major focus of OCC supervision, but “we’ve really tried to make sure that our examiners understand these evolving and changing sanctions, and [that] we can provide the support for the exams and the institutions.”

Ives added that some Fed supervised institutions have taken “a forward-looking view of the next geopolitical target.

“Some of the institutions are already developing potential strategies if there are going to be new sanctions in a new part of the world, how might that affect the supply chain, assets that could get hung-up, parties you can no longer transact with, and how that may impact their operations,” Ives noted.

Using interagency regulatory guidance

On the topic of third-party risk management, both Arquette and Ives noted that updated interagency regulatory guidance is imminent and could be released any day. Use of third parties by financial institutions is increasing, Ives added. “It can be incredibly beneficial, especially in the fintech area where [banks] may need the expertise,” she said. “But how is [suspicious activity report] information going to be shared? Do you have what you need to be on the right side of sanctions compliance?”

The intent of the updated interagency guidance is to make consistent federal banking agency guidance on third-party risk management “to make it manageable and holistic” for financial institutions, Ives said.

A recent survey has found that those in corporate law departments are largely optimistic about the potential for generative AI and programs such as ChatGPT in performing both legal and non-legal work.

In total, 82% of respondents say generative AI can be applied to legal work, while 54% believe it should be applied to legal work, roughly the same rate as their law firm counterparts. Similarly, 70% believe these tools should be applied to non-legal work as well.

The survey, conducted in late April by the Thomson Reuters Institute, gathered insight from more than 580 respondent lawyers and legal professionals within corporate law departments in the United States, United Kingdom, and Canada. The survey forms the basis of a new report, ChatGPT and Generative AI within Corporate Law Departments, which takes a deep look at the evolving attitudes towards generative AI and ChatGPT within departments, measuring awareness and adoption of the technology as well as lawyers’ views on its potential risks.

The report — which pairs with an earlier report done by the Thomson Reuters Institute, ChatGPT and Generative AI within Law Firms — also reveals several key findings that show not only how corporate law departments are approaching their ChatGPT and generative AI plans, but how those plans differ from law firms, and what legal departments want out their law firm partners’ generative AI use. These findings include:

Higher awareness and willingness to apply — Corporate law department leaders surveyed generally had high awareness of ChatGPT and generative AI, with 95% of respondents saying they had either heard of or read about ChatGPT or generative AI. That is higher than the awareness among law firm leaders, of whom 91% said they had either heard of or read about ChatGPT or generative AI.

More comfort with using the technologies — Only a small number of corporate law departments (11%) said they are already using or planning to use ChatGPT and generative AI in their legal operations; however, this was again significantly higher compared to use or planned use by law firm respondents (5%). Among those respondents who said they’re already using or planning to use ChatGPT and generative AI in their operations, 19% of both corporate legal and law firm respondents say they are already using these technologies on a wide-scale basis.

Acknowledgement of the risks involved — Three-quarters of corporate law professionals say they have risk concerns surrounding use of ChatGPT and generative AI, mostly in areas of accuracy, privacy, confidentiality, and security. Further, about one-quarter of respondents said they have received warnings from their companies about ChatGPT and generative AI usage for their work, but only 10% reported ChatGPT and generative AI had been banned at their companies. Many of the objections over AI use in legal work acknowledged the importance of human touch and expertise in the legal profession, the uniqueness and complexity of legal issues, the need for supervision and review of AI-generated materials, as well as ethical considerations and the perception by some that the technology may not be fully ready yet for appropriate use in legal.

Even with the potential risks, general counsel and others are actively preparing for a potentially major change in how work is done. “We’re not shutting our eyes to this,” says one senior legal officer at a large corporation. “We’re working on a solution that would work for us.”

And awareness of generative AI’s potential is likely to spur acceptance and usage, even in the usually reticent legal profession. “Before ChatGPT, technological advancement in legal software has been pretty incremental, but now it appears poised to take big steps toward something significant,” says Gunter Eren, General Counsel in Research & Development at the Business Innovation Centre of Konica Minolta in the U.K.

You can download a copy of the Thomson Reuters Institute’s new report, ChatGPT & Generative AI within Corporate Law Departments, here.

For several years, the SEC has monitored firms’ practices in offering services based on clients’ preferences on ESG and other investing factors related to corporate responsibility along with other factors that go beyond immediate bottom-line concerns.

In the past, the agency has cited the broad provisions of Section 206 of the Advisers Act, which requires disclosure of material facts to bring ESG-related actions. But since last November, the SEC has gained broader authority under the newly implemented Marketing Rule to examine all of firms’ compliance processes for advertising and marketing material, including ESG claims. “We’re testing under the Marketing Rule previously known as the Advertising Rule where you know the basic principle is to not make any misleading advertisement (related to ESG),” said Ashish Ward, the SEC Los Angeles branch chief.

Rulemaking by examination?

Some critics have argued that examiners are pushing ahead with their reviews of ESG at a time when the agency’s own rulemaking process has been facing challenges in defining the basic terms of what constitutes ESG.

However, the SEC sees it differently. Its SEC examinations unit says it has avoided substantive concerns of investment advisers’ ESG decisions, focusing instead on disclosure and documentation. The SEC exam unit also argues that it is implementing risk-based principles based on existing securities law, and it has taken the view that financial services firms must document and disclose the factors that they are using in advising clients.

“While the concern over whether the commission is using its examination or enforcement powers to advance its ESG-related rule making agenda is a fair question to raise,” said Ken Joseph, managing director for financial services compliance and regulation at Kroll. “The commission has already demonstrated in recent enforcement cases that the federal securities laws — including the anti-fraud provisions of the Advisers Act — provide a legal framework for charging alleged false or misleading ESG-related claims or inadequate compliance policies and procedures.”

“Examiners are tasked with evaluating claims made to clients or actual or prospective investors — neither the Marketing Rule nor the proposed ESG-related rule changed that dynamic,” Joseph adds.

Firms face widening ESG compliance risk

With the expansion of rules and priorities by the SEC, what is clear is that the risk of action by the agency because of compliance issues has expanded. Investment advisers will face compliance concerns they have never faced in the past under the new Marketing Rule because the rule adds even more emphasis on raising the bar for compliance units to have processes in place to assure ESG claims are accurate. In addition, the SEC has also created a 22-member Climate and ESG Task Force in its Division of Enforcement to better monitor firms’ and issuers’ ESG practices.

Navigating the complexity in compliance risk for issuers will be tricky in the near term, but adding ESG evaluations in disclosures only adds to the murkiness. “Due diligence can be become difficult with respect to evaluating ESG factors at issuers given the varying types of disclosures that they provide,” explains SEC branch chief Ward, adding that those

Bill Singer of the Brokeandbroker blog, a securities lawyer and former counsel for the Financial Industry Regulatory Authority (FINRA), says some brokerage firms are worried about how the SEC exam unit is viewing ESG. “There are a lot of concerns at firms that the SEC exams can look all over the firm for ESG issues that could pose compliance problems,” says Singer. “I’m hearing from firms that this ESG focus in examinations — and now with a special ESG task force — they will be getting hit with more deficiency letters and enforcement actions. They see it as rulemaking by examination.”

The SEC’s proposed ESG rules in total should give firms a reason to work on their compliance practices in advance of new rules, states law firm Mayer Brown LLP in a recent client note. “Although not directly embedded in any new rule or amendment, an SEC expectation is clearly set out in the proposal: that funds and advisers would adopt new compliance policies and procedures regarding their ESG-related strategies in order to help ensure the accuracy of the various prospectus and brochure disclosures,” the client note states.

“You should look at everything you say [on ESG] and ask if you can substantiate that it’s true,” the SEC’s Ward adds. “That’s going to flow through everything, and that’s going to help fix a lot of problems.”

Environmental, social & governance (ESG) issues represent one of the key areas of complexity in global regulatory landscape. Yet, when asked specifically about ESG, it was the third-most cited risk on the horizon, with one-in-five law departments seeing ESG as a major future risk.

Even more interesting is that data privacy and cybersecurity were also in the top 5 risks on the horizon, according to the survey. Clearly, GCs and CLOs would agree that these two risk concerns are important governance issues as part of the G in ESG. Indeed, looking at top 5 risks on the horizon cited in the survey, one could easily argue that ESG, when including data privacy and cyber-risk, is actually among the most important risks on the horizon.

If we agree that ESG encompasses data privacy and cybersecurity, then ESG rises to the top as one of the most popular risk on the horizon over the next three to five years by corporate legal departments across the world. And while the regional variations are also quite interesting, they send the same message: ESG, including data privacy and cyber-risks, is a key governance issue that is top of mind for many corporate law department leaders.

Taking action on these insights

More importantly, law firms can use this market intelligence to invest in their practices. For example, law firms with ESG practices should be ramping up in the regulatory & compliance areas because this has been cited as the most pressing current priority and one of critical importance in the future. In particular, in-house legal departments are challenged to keep abreast of regulatory changes — and because ESG is a major area of fluctuations in regulatory requirements — law firms would be wise to prioritize their analysis and forecasts of ESG regulations across jurisdictions and highlight new details of reporting requirements of existing regulations and show how clients can meet compliance obligations.

In addition, spotting issues in emerging ESG areas, such as biodiversity, is another consideration. For example, the Task force for Nature Related Financial Disclosures  just released its Beta v0.4 with recommended disclosures, which clients may find confusing and complex.

Decarbonization of their supply chains is another major challenge for companies, particularly for those with complex value chains. There are many components of this issue with which clients may need assistance, such as implications for vendor contracts and outlining new requirements for data reporting in contracts, such as greenhouse gas emissions and certification in forced labor regulations. At the same time, companies need to increase their ability to conduct due diligence of prospective suppliers on human rights and other denied-party screening.

Antitrust issues also are a growing area of concern for companies, in large part because of U..S lawmakers’ recent allegations that industry collaboration on ESG violates antitrust laws, specifically, firms could focus on the “rule of reason” test through the lens of market impact or market power,  as well as delineating business justifications in the U.S.

Finally, employee well-being continues to grow in interest among shareholders and investors, and ESG and diversity, equity & inclusion (DEI) was cited as a top-5 priority for in-house legal departments. This represents a tremendous opportunity for law firms’ labor & employment practices, especially as companies continue to struggle with varied preferences in work flexibility amid remote working frameworks. In addition, companies are consistently in need of updated and expanding HR policies across pay equity, learning & development, as well as DEI, among others.

The existing regulatory landscape is a tough challenge for many in-house lawyers. Moreover, the future remains murky is in this space, according to corporate law department leaders, and in-house lawyers will need the assistance of outside counsel to meet expectations. This leaves law firms with an abundance of business opportunities across ESG practices to seize upon.

Yet the growth rate shown in the most recent report still came as a bit of a surprise: a 20% compounded annual growth rate (CAGR) for the past two years, resulting in a current market size of $20.6 billion. In interviews with leaders from more than a dozen ALSPs, respondents said they expected standout growth in the sector to continue, and survey data from the client side supports these expectations. Among respondents from the largest law firms, 26% said they plan to increase spending on ALSPs, while only 3% said they expect their spending to fall. Within corporate law departments, 21% expect to be spending more on ALSPs in the future, with just 8% expecting spending to drop.

Interview respondents consistently referred to the ALSP market as “opening up” over the past two years, citing a variety of catalysts: changes wrought by the global pandemic, the impact of the Big Four auditing and accounting firms, and the shrinking size of many corporate legal departments, among others. ALSPs are taking advantage of those changes to greatly expand their service offerings; and while the industry is young, a number of ALSP leaders said they’re beginning to see a trend more commonly associated with mature industries: consolidation.

More growth ahead?

A sales director at a U.S.-based ALSP says that ALSPs have moved through the very early stages of the growth curve associated with any new innovation and are now poised for accelerated take-up. Among customers, the innovator and early adopter segments of that base have been using ALSPs for years, and their positive experiences are clearing the way for a wider mass market. “All of a sudden, people will say, ‘Okay, it’s safe now,’” the sales director says, “which will lead to even more expansion.”

He also pointed out that the traditional legal market leaves behind a lot of unmet demand. “Clients simply cannot afford all of the legal and regulatory advice they need to buy,” he says, especially if law firms remain wedded to the billable hour. “There’s this latent demand out there, and if you change your model, you can grab more market share, because [clients] just cannot afford to buy answers by the hour.”

The Big Four have also had a positive effect, says the founder and CEO of a U.S.-based ALSP, admitting that “this is going to sound strange.” The Big Four have convinced many general counsel, CFOs, and CEOs that business and law shouldn’t be so separate, the founder explains. “We found that the Big Four moving into the space has actually just opened up the top of the funnel — it’s so much larger now.”

ALSPs also get a boost from the fact that corporate law departments are shrinking — even though their workloads are not. A founder of an independent U.K.-based ALSP echoes that sentiment. “One of the things we see is that a bigger client doesn’t mean a bigger law department,” the founder says. “Inside legal counsel and inside legal operations are shrinking.” Meanwhile, he adds, inside teams have too much work, or work that isn’t a good fit for their capabilities. Legal departments are even bringing in procurement professionals — a relatively new part of the legal landscape — to try to close that gap in a cost-effective way.

Not surprisingly, the pandemic had an impact as well. “The stigma of offshore support has worn off,” says the vice-president of a U.S.-based ALSP. “We all ended up working from home, and we learned it doesn’t matter where the person is that you’re talking with.”

New opportunities

Together, these trends mean opportunities for ALSPs. The largest seems to be in regulatory & compliance work and advisory work, as well as in technology consulting. ALSPs are also looking to expand into specific service areas, such as labor & employment law, and into new geographies.

The impact of regulations such as the General Data Protection Regulation (GDPR) in the European Union and the California Consumer Privacy Act (CCPA) have produced “a huge focus” on privacy, says a U.S.-based ALSP leader. His firm is partnering with a technology company to provide faster and more focused data breach review. They’re also spending “a significant amount of time” helping clients update their contracts to reflect the new laws.

The new regulations are especially hard to navigate for those organizations that do business across countries and regions. “It’s increasingly complex to operate businesses in multiple jurisdictions and try to manage all of them,” explains the CEO of a law firm captive ALSP in the U.S. “For a lot of our clients, some of their biggest needs are just better use of some of the tools that exist that make it easier to have a good lens on the range of matters our clients have in different jurisdictions.”

Technology consulting, as mentioned in the ALSP 2023 Report, is also a growth area — one that overlaps significantly with legal operations. A partner at a law firm ALSP says his firm is regularly asked to weigh in on matters such as how to manage work, how many lawyers to hire, and where those lawyers should be located. On the technology side, his clients want advice about which technology solution to buy, how it should be implemented, and how it can be made to work best for them. The partner described a typical request as one in which clients say: “I bought some technology, and it’s crap, and it doesn’t work. Help me, because I’ve spent half a million pounds on it, and I can’t admit it doesn’t work.”

Growth through acquisition

As ALSPs grow, it’s not surprising that they become more attractive acquisition targets, fueling consolidation. “In the early stage of this industry we were trying to say, ‘Who do we acquire?’” says the co-founder of a U.S.-based ALSP. “There was nobody of any size to acquire. They were all tiny.” Another ALSP founder expects consolidation to continue, as companies that are strong in one service area — for example, discovery — look to buy a competitor that is strong in a complementary area, such as legal operations.

A partner at a law firm ALSP is already noticing that his competitive set is smaller. “Four or five years ago, I think there were 10-plus providers in the market. There might still be, but you certainly don’t see them. You probably see three or four at the most.” Now, he’s finding his clients are using ALSPs quite heavily, and hire just a handful of providers. His diagnosis of his market segment could just as well apply to the ALSP market as a whole: “It’s grown up,” he says. “It’s matured as a service offering.”

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