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.

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.

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.”

This means that only products that have been produced on land that has not been subject to deforestation or forest degradation after December 31, 2019 may be placed on the E.U. market or exported.

This is just one more sign of the ongoing expansion of regulations focused on risks related to environmental, social & governance (ESG) issues — in this case, those with a focus on the E. However, E is not the alone in this regulation, as respect for human rights will be considered an obligation for a product to be considered deforestation-free.

While this regulation would not ban any country or commodity specifically, companies will not be allowed to sell their products in the E.U. without this type of statement. This means that companies will also have to verify compliance with relevant legislation originating out of the country of production, including those on human rights and the rights of concerned Indigenous peoples.

Scope of legislation

The products covered by the new legislation include cattle, cocoa, coffee, palm-oil, soya, and wood, as well as products that contain, have been fed with, or have been made using these commodities (such as leather, chocolate, and furniture). The MEPs also successfully added rubber, charcoal, printed-paper products, and a number of palm oil derivatives to the list. In addition, the legislation also allows for the addition of new commodities to the list.

Additionally, all banking, investment, and insurance activities of financial institutions are required to take additional action around due diligence in the legislation. Specifically, financial services firms would only be allowed to provide financial services to customers if it concludes that there is no more than a negligible risk that the services potentially provide support directly or indirectly to activities leading to deforestation, forest degradation, or forest conversion.

This is just another global regulation that reinforces the need for companies to conduct ongoing due diligence with respect to their business partners and make every attempt to map their supply chains to the lowest tier possible.

The competent E.U. authorities will have access to relevant information provided by the companies, such as geo-location coordinates, and be able to conduct checks. They can, for example, use satellite monitoring tools and DNA analysis to check where products come from. The final text of the regulation also includes the obligation to precisely geo-locate the specific plot of land involved in the production or farming of the commodities and products in question.

The European Commission (E.C.) will classify countries, or part thereof, into low-, standard-, or high-risk categories within 18 months of this regulation going into effect. Also, the proportion of checks on operators will be performed according to the country’s risk level: 9% for high risk, 3% for standard risk, and 1% for low risk. For high-risk countries, member states would also have to check 9% of total volumes.

​​​​​​​Penalties for non-compliance and lack of due diligence shall be proportionate and dissuasive, and the maximum amount of a fine is set for at least 4% of the total annual turnover in the E.U. of the non-compliant operator or trader. All products linked to deforestation will be required to be withdrawn from the market if they are already present in the E.U. market.

Although the final technical details of the exact wording are still being worked out, the goal is to introduce mechanisms to avoid duplication of obligations and reduce the administrative burden. The final text will also include language that small operators will be able to rely on larger operators to prepare due diligence declarations. This is another example of how the E.U. is taking smaller businesses into consideration when drafting these new requirements.

Next steps

The MEPs and Council will need to formally approve the agreement, which is anticipated. The new law will come into force 20 days after its publication in the E.U. Official Journal, but some articles will apply 18 months later.

The E.C. will step up dialogue with other big consumer countries and engage multilaterally to join efforts, so companies should monitor how these discussions proceed and to what degree these requirements could apply outside the E.U. in the future. For example, a new bill was introduced in the current U.S. Congress in November 2022 that is seen as a response to the E.U. legislation.

While this regulation would not ban any country or commodity specifically, companies will not be allowed to sell their products in the E.U. without this type of statement.

This is just another global regulation that reinforces the need for companies to conduct ongoing due diligence with respect to their business partners and make every attempt to map their supply chains to the lowest tier possible. As the first reports will likely be due to the E.C. by April 2024, putting solid due diligence practices in place now are part of a responsible sourcing strategy. Tools to certify that small suppliers of raw materials are sourced from areas that are not degrading forests no doubt will be required. Moreover, tools that allow users of raw materials in their products to monitor them on an ongoing basis is equally important to ensure compliance is maintained.

At the same time, uncertainty remains. Currently the regulation avoids a clear directive for producer-countries to require standards for human rights or to define what the term deforestation means. Without this, companies may seek to source products from jurisdictions in which relatively weak legal frameworks exist, and thus, could undermine the E.U.’s intent with the regulations.

The need for the E.U. to seek input from all stakeholders— including producer countries; local communities in producer countries; small land users that produce in-scope materials and products and mostly reside in Southeast Asia; local buyers of raw materials that sell them to small-, medium-, and large-sized companies; and multinational companies that purchase the in-scope materials — is necessary to effectively achieve the intent of the overall legislation, which is to ensure sustainable sourcing and avoid deforestation or forest degradation.

What is new?

The CSRD builds upon previous regulations such as the E.U.’s Non-financial Reporting Directive (NFRD) and increases the depth and breadth of organizations that are impacted. Some of what is in the CSRD includes:

• • • New regulations mandate reporting from companies of all sizes — According to the official CSRD guidelines, approximately 50,000 large, medium, and small-sized companies in the E.U. will need to apply the CSRD rules starting between 2024 and 2029. Indeed, large companies or large groups with consolidate subsidiaries must meet two of these three criteria — €40 million in net turnover, €20 million in assets, or 250 or more employees. International companies with subsidiaries located in the E.U. will need to abide by the CSRD if they conduct significant operations there.
    • Impact on society and climate is part of CSRD — A double materiality approach, which requires businesses to disclose climate change related risks as well as the impacts that such risks have on society and climate, will be required by the CSRD, which signals a new approach to unaccustomed U.S. and international companies.
    • The supply chain information mandate is here — The CSRD requires Scope 3 reporting, which includes the collection of sustainability information across a company’s value chain or supply chain. Many U.S. companies have only been reporting their Scope 1 and 2 emissions, if any. Target dates for reporting requirements vary, and reporting exemptions exist as well.
    • Third-party verification for assurance is required — Verification by an independent assurance service provider (g., a third-party audit) will assess the processes that a company has in place for gathering data. This, along with the need to digitalize data, will ultimately require companies to invest in technology to ensure reliable data-gathering processes and a reliable data trail. This is consistent for both the E.U. and non-E.U. parent scoping. At first, limited assurance is sufficient, but the European Commission intends to move to reasonable assurance in the future.

Digitization requirements & costs

Reporting in compliance with the CSRD will incorporate the increasing demand for digitization. Companies will be required to prepare their reporting in XHTML format in accordance with the European Single Electronic Format Regulation. Companies are also required to tag sustainability information within the report according to a digital categorization system, which should be developed with the European Sustainability Reporting Standards (ESRS).

Digitalization in sustainability reporting makes information transfer more efficient and easier to locate. It also promotes transparency and accountability and carries potential significant cost savings for companies. Digitization also allows greater accessibility of data for investors and key stakeholders.

The immediate downside to digitization is the cost factor. While the CSRD requirements will likely lead to higher costs in the short term, the E.C. notes that companies will likely face an increase in costs anyway due to the growing demand for sustainability information. At the same time, the short-term costs are likely to be negated with the goal to incorporate and harmonize reporting requirements in the medium- to long-term timeframe.

Another challenge that remains is the multiple overlapping frameworks and standards already in place, although efforts to align them are evolving. The ESRS need to be consistent with the ambition of the European Green Deal as well as with the E.U.’s current legal frameworks, the Sustainable Finance Disclosure Regulation (SFDR) and the E.U. Taxonomy.

Through the European Financial Reporting Advisory Group, the CSRD has incorporated key elements of the ESRS, which draws upon several existing frameworks including the Global Reporting Initiative (GRI) and the International Sustainability Standards Board-driven (ISSB) Taskforce for Climate related Financial Disclosures (TCFD) framework. In fact, the E.C. supports TCFD to develop the global baseline, and collaboration between GRI and ISSB continues to evolve.

Recommended actions to take now

With the E.U. and CSRD leading the way with the most stringent reporting regulations thus far, international companies need to prepare themselves for the future of reporting in their jurisdictions. For industry professionals facing the challenge of the sustainability regulatory environment, the following actions are recommended:

• • • Get familiar with CSRD regulations — Expanding the rigor of ESG reporting with the CSRD is a key first step. Studying the CSRD and implementing similar reporting standards, such as Scope 3 and double materiality, can give companies a head-start in their reporting journey. In fact, stakeholders and investors are likely to look favorably on the increased transparency and preparedness of the company for upcoming regulation, such as the Security Exchange Commission’s rules on Scope 3.
    • Benchmark with peers — Understanding how peer companies are engaging with Scope 3 emissions and how they approach sustainability reporting are a necessary action to stay up to date on where your organization stands against competitors. U.S. companies unaffected can use the CSRD regulation to analyze how their E.U. competitors are reporting to give them valuable insight for when the requirements from the SEC are updated.

Over the next five years, new regulations around ESG will continue to increase, while deadlines come due for implementation of existing regulations. At the same time, companies in the short term will experience headaches around increased costs and complexity around global frameworks and standards.

What is clear, however, is that ESG reporting requirements are more stringent than ever, and companies need to prepare themselves to meet these new requirements.

Stress in the commercial real estate sector could be the next big concern for U.S. regional banks and regulators, as losses emanating from higher interest rates manifest over the coming months, analysts and bankers say. A portion of this fear stems from the possibility that each regional bank could be the next to suffer a major loss.

As banks report their first-quarter earnings, investors are scrutinizing the results for signs of stress or weakness following SVB’s collapse last month. So far, the earnings picture has not revealed any hidden bombshells, but experts say the pressures on banks’ financial health are likely to become more pronounced in the months ahead.

Of greatest concern is the banking sector’s exposure to commercial real estate (CRE), particularly the office sector. “Compared to big banks, small banks hold 4.4-times more exposure to U.S. [CRE] loans than their larger peers,” stated a new analysts report from JPMorgan Private Bank. “Within that cohort of small banks, CRE loans make up 28.7% of assets, compared with only 6.5% at big banks,” the report continued. “More worrying, a significant percentage of those loans will require refinancing in the coming years, exacerbating difficulties for borrowers in a rising rate environment.”

A separate Citigroup analysis found that banks represent 54% of the overall $5.7 trillion commercial real estate market, with small lenders holding 70% of CRE loans. More than $1.4 trillion in U.S. CRE loans will mature by 2027, with approximately $270 billion coming due this year, according to real estate data provider Trepp.

High vacancy rates

The office sector faces significant challenges following the COVID-19 pandemic, which forced a potentially permanent shift to remote work for millions of employees. A seismic shift in employee mentality following a period of flexible, remote working has led to a continued acceptance of remote and hybrid opportunities. With this change, office vacancy rates remain high across many U.S. cities. The current overall vacancy rate of 12.5% is comparable to where it was in 2010, one year after the onset of the Global Financial Crisis.

Further, chief executives from some of the largest banks have pointed to risks in the commercial real estate sector. “Weakness continues to develop in commercial real estate office,” said Wells Fargo Chief Executive Charlie Scharf on a recent earnings call with analysts. The bank set aside an additional $643 million in the first quarter for credit losses, mainly driven by expectations of higher CRE loan defaults.

California market in focus

With the tech and venture capital sector having borne the brunt of SVB’s collapse, recent data shows that California’s CRE market is one of the hardest hit in the country. San Francisco and Los Angeles had an average office vacancy rate of 21.6% in the first quarter, according to data from commercial real estate firm Cushman & Wakefield. And loans for San Francisco offices now face the highest risk of default of all U.S. metro areas.

“Difficulties are emerging by geography,” noted the JPMorgan report, adding that “Chicago and San Francisco are much more challenged than Miami, Raleigh, and Columbus, for example.”

CRE weakness is likely to affect banks of all sizes, but small and regional banks have, on a percentage basis, the greatest exposure. “While total exposure to the weakest CRE subsectors varies by bank, those with more than 100% of their capital in these buckets are more likely to be smaller regional entities,” the JPMorgan report stated, noting that Webster Financial Corporation, Valley National Bancorp, and Zions Bancorporation are a few of the banks with exposures exceeding 100% of their capital.

The bank’s base case scenario “assumes that aggregate CRE prices fall approximately 10% to 15% in the current cycle,” although for the office sector, the report revealed that price declines of 30% to 40% in the most stressed markets would be unsurprising.

The Carbon Disclosure Project estimates that Scope 3 emissions account for an average of three-quarters of a company’s emissions, according to the World Resources Institute. “Other studies show that the supply chains of eight sectors account for half of the world’s [greenhouse gas] GHG emissions and provide evidence that Scope 3 emissions from energy-intensive industries are increasing faster than their Scope 1 and 2 emissions.” Indeed, counting Scope 3 emissions is of paramount importance.

Variations in carbon emissions regulations make reporting murky

In the U.S., the Securities and Exchange Commission (SEC) mandates the disclosure of Scope 1 and Scope 2 emissions. According to the United Nations Global Compact, Scope 3 emissions account for approximately 70% of the average corporate value chain total emissions and are 11-times higher than Scope 1 emissions. Under SEC rules, Scope 3 emissions are only required to be disclosed if they are material or if the companies have Scope 3 emission targets. Currently, around 7,000 publicly traded companies are covered by this regulation.

By contrast, the Corporate Sustainability Reporting Directive (CSRD) in Europe is much broader. It includes 49,000 medium and large companies, covering all private and public companies with at least 500 workers. The European regulation affects more than 10,000 non-European companies, of which 30% are U.S. companies, according to data from Refinitiv.

Adding to the complexity of regulation is that specific rules within the regulation across countries and states or provinces can vary widely. As of August 2020, at least 40 countries required facilities or companies to measure and report their emissions periodically. With this list growing, it is good news that the GHP is the go-to resource for calculations and that additional harmonization of emission standards is ongoing.

Double counting not really a concern

When it becomes a legal requirement, accurate and homogenous collection, standardization, and reporting of Scope 3 emissions will be critical for both reporting companies and those using the data to make investment decisions.

Collecting data on Scope 3 emissions requires information from multiple sources, such as suppliers, customers, and other stakeholders, making it difficult to obtain accurate and reliable data. This affects the quality of the data, as it can vary or be incomplete or inaccurate. To combat this, companies may need to use multiple methods to collect data from various sources, which can come at a cost, especially for those with complex value chains.

While, as mentioned, the GHP has developed the corporate value chain accounting and reporting standard methodology for measuring and reporting Scope 3 emissions, one of the main criticisms around universal counting of Scope 3 emissions is the potential for double counting. This is because one company’s Scope 1 emissions are another company’s Scope 3 or Scope 2 emissions — and in some industries, the possibility exists for multiple companies to use the same supplier.

Collecting data on Scope 3 emissions requires information from multiple sources, such as suppliers, customers, and other stakeholders, making it difficult to obtain accurate and reliable data.

Double counting may occur when a manufacturer and a retailer both account for Scope 3 emissions resulting from the third-party transportation of goods between them. This only becomes problematic when claims are made that these emissions are offset with credits or provide a monetary value and when the same activity, such as the transportation of goods, is offset by another company. There are many other examples of double counting; for example, it may be acceptable to double count when a specific emissions goal is tracked over time and its progress needs to be reported.

Clear communication of reporting boundaries and emissions calculations can help identify potential overlaps and ensure that each company reports only its own emissions. This approach can provide a more accurate picture of a company’s carbon footprint and more fully support efforts to reduce emissions across the value chain.

Further, the GHP understands the need for additional clarification and is working towards the harmonization of U.S. and European disclosure rules. Additional guidance on this important subject is expected to ensure any double-counting concerns are alleviated.

“What we’ve really seen… is how quickly the DeFi space has grown over the past couple of years, and we’ve also seen the unfortunate, significant use of DeFi services in the context of large heists… as well as other forms of illicit finance,” said Brian E. Nelson, Treasury Under-Secretary for Terrorism & Financial Intelligence. His comments came during an online discussion held recently by the Association of Certified Anti-Money Laundering Specialists (ACAMS).

So-called DeFi platforms allow users to lend, borrow, and save, usually in crypto assets and stablecoins, without using banks.

“While it is true the space is relatively small and that it’s a relatively small proportion of the illicit finance we face in the United States… it is a sector that’s growing very rapidly and the risk is growing along with it,” Nelson said, adding that the use of DeFi by “serious threat actors” such as North Korea “is the reason why we believe it’s so critical to address this now.”

Message to the private sector

The private sector should use the findings of the new risk assessment to inform their own risk mitigation strategies and to take clear steps, in line with anti-money laundering and countering the financing of terrorism (AML/CFT) regulations and sanctions obligations, to prevent illicit actors from abusing DeFi services, Treasury said.

In a statement announcing the release of the 42-page risk assessment, Treasury said there was currently no generally accepted definition of DeFi, adding that the term “broadly refers to virtual asset protocols and services that purport to allow some form of automated peer-to-peer transactions, often through use of self-executing code known as ‘smart contracts’ based on blockchain technology.” Criminals can exploit vulnerabilities, including the fact that many DeFi services with AML/CFT obligations fail to implement them, Treasury said.

“Risk assessments play a foundational role in promoting understanding of the illicit finance risk environment and more effectively protecting the integrity of the U.S. financial system,” Nelson said in Treasury’s written statement. “Our assessment finds that illicit actors, including criminals, scammers, and North Korean cyber-actors are using DeFi services in the process of laundering illicit funds.”

DeFi vulnerabilities

The primary vulnerability exploited by illicit actors stems from DeFi services’ failure to comply with AML/CFT regulations and sanctions obligations, the assessment said.

Criminals use a variety of techniques and services to launder ill-gotten gains, such as trading virtual assets for less traceable alternatives, sending virtual assets through mixers, and placing virtual assets in liquidity pools as a form of layering, the statement noted. “In many cases, criminals use DeFi services for these purposes without being required to provide customer identification information,” the statement said. “This can make DeFi services more appealing to criminals than centralized (virtual asset service providers), which are more likely to implement AML/CFT measures.”

Other vulnerabilities include the potential for some DeFi services to fall outside the scope of existing AML/CFT rules, weak or non-existent AML/CFT controls for DeFi services in other jurisdictions, and poor cybersecurity controls by DeFi services, which enable the theft of funds, Treasury said.

Treasury’s risk assessment also included six recommendations for U.S. government action to mitigate the illicit finance risk associated with DeFi services. They are:

1. 1. 1. 1. Strengthen U.S. AML/CFT supervision of virtual asset activities.
         2. Assess possible enhancements to the U.S. AML/CFT regulatory regime as applied to DeFi services.
         3. Continue research and engage with the private sector to support an understanding of developments in the DeFi ecosystem.
         4. Continue to engage with foreign partners.
         5. Advocate for cyber-resilience in virtual asset firms, testing of code, and robust threat information sharing.
         6. Promote responsible innovation of mitigation measures.

Treasury also posed several questions and said it welcomes public input. The questions included:

• • • • What factors should be considered to determine whether DeFi services are considered a financial institution under the Bank Secrecy Act (BSA)?
      • How can the U.S. government encourage the adoption of measures to mitigate illicit finance risks… including by DeFi services that fall outside of the BSA definition of a financial institution?
      • Are there additional recommendations for ways to clarify and remind DeFi services that fall under the BSA definition of a financial institution of their existing AML/CFT obligations?
      • How can the U.S. AML/CFT regulatory framework effectively mitigate the risks of DeFi services that currently fall outside the BSA definition of a financial institution?
      • How should AML/CFT obligations vary based on the different types of services offered by DeFi firms?

In this environment, robust and proactive compliance infrastructure is imperative to safeguard businesses and the broader macroeconomic landscape. U.S. Deputy Attorney General Lisa Monaco recently called on today’s business leaders to prioritize corporate compliance — not only to uphold the rule of law, but to recognize the role of compliance in strengthening financial markets and protecting national security.

At a time when internal budgets are being squeezed, the Department of Justice is doubling down on policy-driven strategies to hold both organizations and their leadership accountable “to promote and support a culture of corporate compliance,” she said. For workplaces today, where culture is key, Monaco’s remarks on safeguarding the business with a tenacious compliance and risk management posture are critically important.

Striking a healthy balance

Corporate departments and business units are often considered either as a cost center or profit center. During times of heightened economic pressure, unsurprisingly, the cost centers are often the first to be assessed for possible budget freezes or cuts to boost cost savings. In most organizations, the risk & compliance function is perceived as a cost center.

However, the role of an effective head of compliance is to communicate the importance of the compliance department and approach the role of the function as not only as a cost center, but as a way to drive business development and revenue. This requires striking a healthy balance between compliance and other leadership teams, articulating the business value of building a robust compliance program that assesses and mitigates risk.

A successful compliance program is designed around a heat map-like calculation, an exercise that evaluates the likelihood of risk against the impact of the stated risk. Adept compliance leaders will assess the industry environment, scan the horizon, and determine how certain variables might manifest as risks within their own organizations. This exercise is fundamental to quantify — and justify — the budget of a sophisticated compliance program that is equipped to safeguard the business.

Establishing a workplace compliance culture

Prioritizing compliance is not exclusively the role of the company’s compliance officer; in fact, if the compliance team is the only function of the business thinking about compliance and implementing the appropriate controls, the organization is not set up for success. From the senior leadership and board of directors, down to the roots of the organization, all employees are responsible for contributing and upholding a culture of integrity and compliance.

The top-down implementation of policies and expected behaviors, supported by good line management, can promote a more compliant and consistent approach across the business to better create a positive risk management culture. Establishing a strong culture includes fostering an entire organization’s approach to compliance, ensuring proportionate and cost-effective use of resources, and supporting efforts to build a dynamic and inclusive organization by promoting a speak-up culture.

Just as it is the role of all employees to strive towards annual business targets, so too is their role in upholding the organization’s compliance and ethics initiatives. It is equally important for organizations’ heads of sales to prioritize risk management and compliance as it is for heads of compliance themselves. The commitment to remain compliant is the responsibility of the entire organization.

The changing role of the compliance officer

The need to establish a robust compliance program, backed by a workplace culture that prioritizes de-risking and integrity, has become increasingly important for businesses today as policy and regulation continue to evolve. In February, a judge’s decision in a derivative lawsuit in Delaware to allow a shareholder lawsuit to go forward against a former McDonald’s Corp. HR leader set a meaningful industry precedent, another signal in recent regulatory activity that is continuing to shift accountability from the organization alone to include individuals as well.

This evolution of accountability over the last several years has been one of the most fundamental transitions in the role of the corporate compliance officer. Most importantly, this shift has changed how compliance leaders interpret their role and responsibility to the organization. When an individual is personally on the hook, it magnifies the context of accountability.

Coupled with this transformation is the U.S. government’s growing expectation to see data-driven approaches to compliance. Regulators increasingly require proof, backed by data and analytics, that a robust compliance program is in place and reinforced by a compliance-first culture.

Like most business functions, the increased use of technology and data has streamlined processes and accelerated efficiencies within compliance. Specifically, compliance leaders who are taking a more proactive approach to controls are looking to leverage data in order to understand how to better allocate limited resources across the business to areas that may be more at risk. As technology becomes even more sophisticated, so too does the expectation of the compliance officer’s responsibility to leverage it.

Compliance as a business driver

The most ethical and stable organizations are the ones with leadership teams that accept the ownership of risk, establish programs to mitigate risks, and leverage the compliance team as a vital resource to run the business more successfully. Especially as economic challenges persist, it is a business imperative that organizations — across all levels and functions — are committed to compliance.

At this year’s National Institute on White Collar Crime hosted by the American Bar Association, Deputy AG Monaco spoke about these recent policy changes that seek to promote cultures of corporate compliance and reinforce the personal role of individuals. “These policies empower general counsels and compliance officers to make the case to company management, to make the case in the boardroom that investment in a robust compliance program, including a forward-leaning compensation system, is money well spent,” she said.

While this is true in any climate, it is especially critical in today’s macroeconomic landscape. Indeed, it is the role of the corporate compliance officer that breathes this ethos into the organization to not only safeguard the business but to continue driving it forward.

Congress enacted the transparency legislation as part of the AML Act of 2020. It aims to stem criminal abuse of shell companies by creating a national registry to identify the beneficial owners of complex corporate and legal structures. Slated to be operational on January 1, 2024, the registry will ultimately contain data on tens-of-millions of legal entities.

The senators’ letter urged the Financial Crimes Enforcement Network (FinCEN) to amend a proposed rule governing access to the non-public registry. As written, the proposal “deviates from congressional intent by inappropriately restricting financial institution access to and use of (beneficial ownership information, or BOI),” it said.

The proposal’s public comment period ended in mid-February 2022, but not before the American Bankers Association (ABA), an influential trade group, submitted a letter labeling it “fatally flawed” and recommending its withdrawal. The proposed access rule “creates a framework in which banks’ access to the registry will be so limited that it will effectively be useless, resulting in a dual reporting regime for both banks and small businesses,” the ABA said.

The senators’ letter to FinCEN seemed to support elements of the ABA’s position, calling on regulators to ensure that financial institutions can use beneficial ownership information across their anti-money laundering, combating the financing of terrorism (CFT), sanctions-screening, and broader financial crime compliance programs.

Access rule should “track closer” to Congressional intent

Senators Sheldon Whitehouse (D-RI), Chuck Grassley (R-IA), Ron Wyden (D-OR), Marco Rubio (R-FL), and Elizabeth Warren (D-MA) submitted the letter, stating they want FinCEN’s rulemaking to “track closer” to Congress’s intent in the CTA.

“As drafted, this proposed rule risks impeding financial institutions’ timely access to the beneficial ownership directory,” the senators said. “Once the database is live, financial institutions across the country will immediately begin requesting access to BOI for the 32 million reporting companies in the country. It is essential that FinCEN establish an automated process (ideally one that integrates with existing compliance systems at financial institutions) for fielding and responding to these requests.”

The letter adds: “If FinCEN manually reviews every request from each financial institution, it risks overwhelming the capacity of the agency, generating major delays in the financial system, and undermining the utility of the directory.”

FinCEN takes feedback from public comments on its proposed rule “very seriously” and “are carefully considering all comments as we complete our work,” a FinCEN spokesperson stated. “FinCEN is committed to implementing an effective regime that enhances transparency on who ultimately owns or controls a company and to making this historic beneficial ownership database a highly useful tool for all stakeholders, including financial institutions, and others.”

The senators also urged FinCEN to clarify in the final rule that financial institutions “are not expected to affirmatively obtain new consent from an existing reporting company customer each time a financial institution needs to query the directory for information on such customer — assuming the customer previously provided the financial institution with its consent to request BOI from FinCEN.

“The current proposal could be read to forbid financial institutions from accessing the directory to assist with most of their Bank Secrecy Act, anti-fraud, and sanctions-screening requirements,” the letter also stated. “Congress intended that the directory be ‘highly useful’ to financial institutions, among other authorized users, and the CTA explicitly contemplates that financial institutions will incorporate BOI into their AML/CFT programs.”

Notably, however, the senators’ letter did not address all of the ABA’s concerns. It did not, for example, ask FinCEN to allow banks to share BOI with bank personnel in foreign jurisdictions, nor did it request a safe harbor from liability for financial institutions that use information obtained from the registry.

Other requested amendments

In addition to urging greater registry access for financial institutions, the senators also asked FinCEN to make other adjustments to the proposed access rule, including:

• • • Ensuring that state, local, and tribal law enforcement can effectively access the beneficial ownership directory.
    • Ensuring that beneficial ownership information can be used in court at the conclusion of a case.
    • Nixing and clarifying certain filing requirements that, as drafted, risk slowing investigations, overwhelming FinCEN’s capacities, and/or generating major delays in the financial system.
    • Ensuring that Treasury’s Office of Inspector General and the Comptroller General of the United States have access to the registry.
    • Mandating that FinCEN verifies the beneficial ownership information it receives.
    • Ensuring FinCEN creates clear, concise, and tailored templates, forms, training videos, and step-by-step guides to help authorized recipients request and access the registry.