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.

It remains to be seen whether the Treasury’s document will have any impact on de-risking, but experts expressed well-founded skepticism following its release last week.

De-risking has been a major issue in the United States since shortly after the 9/11 terrorist attacks and the enactment of the USA PATRIOT Act of 2001. At the time, embassies, money services businesses, and charities were the first sectors to be seen as too risky, or as posing too high a compliance cost, to banks. In recent years, however, de-risking has grown in the correspondent banking space and has left people in some regions and even nation-states unable to receive funds transfers — such as desperately needed remittances from family members — from the United States.

Treasury’s 54-page De-risking Strategy, which was mandated by Congress in the Anti-Money Laundering Act of 2020, probes the phenomenon of de-risking and outlines its causes, victims, and recommended policy options to combat it. Treasury said the administration of President Joe Biden “places a high priority on addressing de-risking, as it does not only hurt certain communities but can pose a national security risk by driving financial activity outside of regulated channels.”

De-risking has been a major issue in the United States since shortly after the 9/11 terrorist attacks and the enactment of the USA PATRIOT Act of 2001.

Wally Adeyemo, Deputy Treasury Secretary, stated that “broad access to well-regulated financial services is in the interest of the United States. [And] this strategy represents the next step in Treasury’s longstanding commitment to combatting de-risking and highlights the importance of financial institutions assessing and managing risk.”

Treasury said it engaged in “extensive consultation” with the public and private sectors — including banks, money service businesses (MSBs) of various sizes, diaspora communities that depend on these businesses for remittances, and other small businesses and humanitarian organizations to better understand the impacts of de-risking. Unsurprisingly, Treasury found that “profitability is the primary factor in financial institutions’ de-risking decisions” and that the costs of conducting adequate due diligence and doing other anti-money laundering or counter-terrorist financing (AML/CFT) work is a key element of the decision-making process.

Other factors fueling de-risking “include reputational risk, risk appetite, a lack of clarity regarding regulatory expectations, and regulatory burdens, including compliance with sanctions regimes,” the strategy paper states, also noting that banks interviewed by Treasury said: “They tend to avoid certain customers if they determine that a given jurisdiction or class of customer could expose them to heightened regulatory or law enforcement action absent effective risk management.”

The strategy document also states that the customers facing de-risking challenges “most acutely” include: MSBs that offer money-transmitting services, non-profit organizations (NPOs) operating in high-risk jurisdictions, and foreign financial institutions with low correspondent-banking transaction volumes, particularly those operating in financial environments characterized by high AML/CFT risks.

Strategy recommendations

The Treasury’s strategy document makes several counter-de-risking recommendations for the federal government, including:

• • • Promoting consistent supervisory expectations, including through training to federal examiners, that consider the effects of de-risking.
    • Analyzing account termination notices and notice periods that banks give to NPO and MSB customers and identify ways to support longer notice periods when possible.
    • Considering regulations that require financial institutions to have reasonably designed and risk-based AML/CFT programs supervised on a risk basis, possibly taking into consideration the effects on financial inclusion.
    • Considering clarifying and revising AML/CFT regulations and guidance for MSBs in the Bank Secrecy Act(BSA).
    • Bolstering international engagement to strengthen the AML/CFT regimes of foreign jurisdictions.
    • Expanding cross-border cooperation and considering creative solutions involving international counterparts, such as regional consolidation projects.
    • Supporting efforts by international financial institutions to address de-risking through related initiatives and technical assistance.
    • Continuing to assess the opportunities, risks, and challenges of innovative and emerging technologies for AML/CFT compliance solutions.
    • Building on Treasury’s work to modernize the U.S. sanctions regime and its recognition of the need to calibrate sanctions precisely, in order to mitigate unintended economic, political, and humanitarian consequences.
    • Reducing burdensome requirements for processing humanitarian assistance transactions.
    • Tracking and measuring aggregate changes in banks’ relationships with respondent banks, MSBs, and non-profit organizations.
    • Encouraging continuous public and private sector engagement with MSBs, non-profit organizations, banks, and regulators.

No short-term fix

Of course, Treasury’s strategy will not significantly impact the de-risking challenge in the short term. In the past, Treasury has hosted public-private sector dialogues and has encouraged financial institutions to rethink their de-risking practices, but nothing notable has been achieved.

Further, the U.S. government has no authority to force financial institutions to serve particular customers or even customer types, so the most viable government solutions to de-risking lie in making financial institutions comfortable accepting customers that may pose high financial-crime risks, while lowering the compliance costs associated with banking such customers.

Some of the recommendations above, particularly the promotion of consistent supervisory expectations, could potentially have a modest impact, but not in the short term, according to veteran AML compliance officers at two U.S. financial institutions.

The South Florida-based Financial & International Business Association (FIBA), a trade group, has long called on the U.S. government to address de-risking. “To me, the importance is that Treasury has issued a comprehensive document outlining the true reasons why de-risking occurred and [why it] continues to impact key areas such as correspondent banking,” explained David Schwartz, FIBA’s president and chief executive. “The strategies, however, are not new and do not provide a solution to this complex problem.”

Treasury plans to continue its dialogue with the private sector. “In the coming weeks and months, Treasury will be reaching out to partners in the public and private sector to coordinate the best path forward to implement the recommendations in the strategy,” the agency stated.

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.

Option 1: Non-technical default

The U.S. Treasury has a couple different options if the “extraordinary measures” which are forestalling the crisis reach their breaking point. The Secretary of the Treasury could make the choice to continue paying bond holders, prioritizing them in order to avoid a technical default. Such an action would avoid the common meaning of default, as the U.S. would continue to fulfil its obligations to its lenders. This would also give the government cover to avoid the greatest harms to international trade and the currency regime, but it is unlikely to escape without significant harm to its standing and reputation.

While technically avoiding default, reaching this point would expectedly lead to downgrades in the country’s credit rating and increased interest rates more broadly, as was seen in the near default of 2011. The more significant impact this time would be to the domestic economy. Prioritizing bonds would result in substantial domestic spending cuts as the Treasury would divert its already insufficient cashflow to repay lenders. Payments to state programs, healthcare, Social Security, and military spending would thus see a larger contraction in funds than they would be otherwise. The U.S. would almost certainly enter a recession with high unemployment.

The U.S. plunging into recession would cause other fragile economies to enter into recession as well, pulling down global economic demand. However, this scenario would more resemble a traditional global recession, the type of which has been navigated and documented previously. While having its own unique challenges, non-technical default would be more familiar to organizations and businesses than Option 2.

Option 2: Classic default

In this circumstance, domestic spending has been given priority over bond holders and the U.S. government defaults on its debt. Immediately, the U.S. dollar experiences a sharp decline in value relative to other currencies, as last-minute hopes of a political compromise are dashed. Subsequently, import prices skyrocket and inflation could spike rapidly. Investors will then begin to sell off U.S. Treasuries at a high volume, likely at a loss that will hamper global access to liquid capital.

The U.S. plunging into recession would cause other fragile economies to enter into recession as well, pulling down global economic demand.

With the loss of the supposedly most safe and stable asset, financial institutions’ balance sheets would become fragile in a way that they haven’t since the Global Financial Crisis of 2007-’08. The Federal Reserve would need to immediately announce emergency measures to support financial markets and prevent a total collapse of the financial system.

This then would likely be followed by other countries reducing their dependence on the dollar as the international reserve and trade currency. The U.S. has greatly benefited from its place as the standard currency for international finances, trade, and economic stability. A default on its debt from something as innocuous as failing to raise the debt ceiling will end this status. Other countries, namely China but also potentially the European Union, India, and Japan will try to push their currencies as the new standard-bearer, but this process will be messy, and it will take time.

Meanwhile, the rapid exchange of currencies will cause chaotic fluctuations in exchange rates and make global trade immediately more difficult. Combined with the crisis in the international financial system that the Federal Reserve will be struggling to hold together, a liquidity crisis becomes possible, which would strangle global trade in the short term. Ships will be stuck in ports as companies and governments alike struggle to raise the funds to free them while valuable commodities lie frozen in the supply line as buyers work to stabilize their balance sheets and avoid illiquidity. The resulting seesawing of prices will only make trade more difficult and more expensive.

Bond holders will not be the only ones seeing their cash flows stop. State spending and major social programs in the U.S. will also see funds frozen, though to a lesser extent than a non-technical default would see. The combination of fiscal cuts combined with a financial crisis will still plunge the world’s largest economy into recession.

It’s difficult to do more than hypothesize what global trade would look like in a post-default world, but it would most likely be dramatically more costly and less accessible.

The price of oil and other commodities will experience significant fluctuations. Global inflation will probably reignite as the benefits of a sole global reserve currency are lost, and the additional costs of more expensive trade will be felt broadly. Countries will seek to reduce their reliance on the U.S. in as many ways as possible, including creating new trading blocs which would become more isolated from one another as the global economy becomes more splintered. The resulting barriers to trade and global supply chains will likewise make global trade more difficult and, again, more expensive.

The long-term impacts

In the medium- to long-term there would be a global recession and higher costs of doing business for everyone involved. Without a dominant global trade regime, trading blocs will vie for supremacy, perhaps erecting barriers to trade such as requiring business to be done solely in the bloc’s currency of choice, be it the euro or yuan. Money will be tight, and importers and exporters will face delays or maybe even find their jobs impossible for long stretches of time until the new global market dynamic has a chance to emerge.

Despite rising labor costs in countries such as China, the economic disruption may further hamper movement of manufacturing to lower-cost developing countries, further pushing up costs and hampering global economic growth. Yet, out of everyone impacted, the U.S. will be the one left the most scarred. Thrown into a deep recession, its financial system and credit facing the greatest challenge since not 2008, but rather 1929, the prosperous United States at the center of a global economy will become a memory.

It’s difficult to do more than hypothesize what global trade would look like in a post-default world, but it would most likely be dramatically more costly and less accessible. The good news is that default remains unlikely. As stated previously, the United States has always managed to raise the debt ceiling before reaching the default state. After all, countries tend to avoid courting economic collapse simply to score domestic political points. Given events such as Brexit however and the failure of some countries to properly respond to global crises like the pandemic, such cataclysmic events cannot be ruled out entirely. Companies and governments alike should be prepared for the previously unthinkable to possibly happen.

Our recent research into the UK’s competitive legal landscape compared UK clients’ usage and perceptions of Magic and Silver Circle law firms with their perceptions of those US-based firms that have built out a strong presence in the country. We also look at how US-based firms are demonstrating strategies of scalability and differentiation in order to carve out a strong position in the UK legal market.

A sector focus

Entering a market is never as simple as putting boots on the ground and waiting for clients to call. US-based law firms have come from strong vantage points in their home territory and have been able to leverage that to get their feet in the door in the UK. One tactic that appears to be emerging is US firms being able to identify with which clients a successful relationships could be built.

The chart below shows a sector breakdown of the UK clients that think of Magic and Silver Circle firms in a top-of-mind manner, compared to those that think of US-based firms in that way. The disparities are clear: UK clients in more traditional, well-established sectors — such as banking, manufacturing, and energy — drive a bigger proportion of awareness for Magic and Silver Circle firms. Meanwhile, UK clients in heavily evolving sectors such as pharmaceuticals and investment represent a much larger share of US firms’ UK awareness. These sectors typically have interests in both the UK and the US and make up similar proportions of client awareness in both jurisdictions. As a result, it makes sense for firms with experience in these practice areas and industries to strategically target such clients when developing their client base.

Scaling up

Further, the ability of US firms to attract UK lawyers has caused some concern among UK-based firms. The most practical — and effective — way to increase top-of-mind awareness in a legal market is through lawyer outreach; therefore, the bigger the firm’s headcount, the more likely these firms are to be sitting top of mind for UK clients.

For example, Latham & Watkins has successfully employed this strategy to make strong headway into the market and has driven a high rate of growth in both its awareness and favorability in the UK over the past 10 years.

Indeed, a look into the strategies used by Latham & Watkins and Kirkland & Ellis show how the investments these firms have made in UK lawyer headcount have helped them carve out an increasing rate of top-of-mind awareness among UK legal market clients.

Differentiating in a globalized market

Yet, size is only one strategy law firms can use to grab a larger share of the market. Specialization around a particular segment of the market is another effective approach, whether it’s being known as the best in a particular sector, region, or work type. It’s also this strategy that has driven Kirkland & Ellis’ position in the minds of UK-based clients.

Kirkland & Ellis may not be the law firm that UK-based clients think of first in a general setting; however, that changes when you ask these same clients which firm they would consider for their top-level or cross-border deals. Kirkland & Ellis is the only firm that UK clients name more frequently for deal consideration than for general awareness. (Note: Only firms with five or more counts for top-of-mind awareness were considered in this measure.)

The fact that Kirkland converts awareness into consideration for M&A work more than other firms in the UK market is indicative of the threat they pose to incumbent Magic and Silver Circle firms. In the case of Kirkland & Ellis, size isn’t driving their market share growth, rather it is client consideration that’s coming from the firm’s reputation for success in M&A work which is hard to challenge. Latham & Watkins has followed a similar strategy, focusing on building its brand position with high-priority banking & finance work, demonstrating a strong go-to-market strategy around these practices within the UK market.

Favorability

We have discussed the what, in terms of work types, that US firms are using to build their brand position within the UK market. To understand the why, however, we need to look further into what clients say is driving their favorability for a particular law firm. For example, UK clients that favor Magic Circle firms are much more likely to favor them for their specialization and breadth of service — in fact, approximately one-in-six clients say they appreciate the firms for their range of service offerings.

However, building a firm’s reputation as an expert takes time and resources — both of which Magic Circle firms have been able to put in place over many years. By growing to understand the needs of the market, these legal powerhouses have been able to build out the breadth of their services and become specialists in particular areas, which is reflected in what clients say they favor about these firms.

However, US-based firms are favored by UK clients for an entirely different skill set, indicating these firms are filling a unique hole that was existing within this market.

US firms see larger proportions of their favorability being driven by their client focus, accessibility, and approachability. Clients are being made to feel like they are being listened to by these firms, and that these firms are demonstrating their ability to be agile in their responsiveness. This is a great way to leverage better interactions with clients and gather information for business-generating conversations. Keeping their ear to the floor and listening to clients’ demands is key for an effective growth strategy.

Indeed, in the past 12 months through June 2022, 50% of UK clients said that they had adjusted their law firm rosters in the past 12 months, a sign of how quickly neglected client relationships can be lost.

Conclusion

As US firms scale up the size of their UK operations, focusing on offering high-value services to clients operating in growing sectors, building reputations as trusted advisors through client-centric relationships, and moving further into the thoughts of UK clients, Magic and Silver Circle firms shouldn’t panic… yet.

They still possess the lion’s share of consideration for work types and measures of awareness and favorability in the UK; however, they must be aware of the strategies being utilized by US firms that could result in Magic and Silver Circle firms eventually losing out on business.

You can learn more about transforming the quality of your strategic decisions with financial performance metrics and global market research insights, here.

The recoil from the 2008 financial crisis changed compliance’s standing across the world. Governments reversed light-touch policies and once supine regulators harried firms about breaches and anti-money laundering (AML) failings. Not surprisingly, new regulations followed, such as the European Union’s Fourth Capital Requirements Directive, the Market Abuse Regulation, the Fourth Anti-Money Laundering Directive and the revised Markets in Financial Instruments Directive (MiFID II). With more regulation to comply with and dire penalties for breaches ($8.4 billion worldwide for AML alone in 2016), firms boosted compliance headcount and budgets as regulatory focus broadened around the world, notably in the United Kingdom, mainland Europe, the Asia-Pacific region, and the Middle East.

“Substantial regulatory enforcement in the 2010s, especially by regulators and government agencies in the United States, drove significant investment in financial crime functions,” says Tom Salmond, a UK financial services partner at EY. “This was accompanied by multi-year programs to remediate historic issues, tighten up existing policies, implement new systems, and build stronger data and operational capabilities.”

Fresh challenges

Firms hardly loved the extra expense — a mindset that compliance stops the company from doing business lingered at large firms and persists at some smaller ones — but leaders realized the necessity of the compliance function. Spending on compliance often peaked while firms built up teams and systems, but EU and UK regulators have made it clear they must maintain effective compliance.

“Some firms have reduced teams from previous highs as they were in a change mode and now are in ‘business-as-usual,’” says Mark Spiers, a partner in the regulatory consulting firm Bovill in London. “However, those resources still need to be adjusted over time according to the risks faced by the particular firms.”

A downside of having substantial resources, however, is that senior management assumes compliance can undertake more tasks, especially when economic uncertainty means cost reductions are sought. Today, fresh challenges requiring compliance input include the regulatory consequences of data- and cybersecurity breaches, expanding climate impact reporting, guided investment in environmental, social, and governance (ESG) initiatives, and firms exploring the opportunities of the crypto-sphere.

Regulatory onslaught

Further, regulation keeps evolving and compliance has to ensure that its systems and processes will keep up. The EU is overhauling key provisions in some existing regulation, including MiFID II and the Alternative Investment Funds Manager Directive. Also, major new regimes such as the Markets in Crypto-Assets Regulation and the Corporate Sustainability Reporting Directive are expected to take effect in in 2023 or 2024. And the UK’s new Consumer Duty applies from next July, while the Financial Services and Markets Bill proposes substantial changes to the mechanisms of regulation.

To better keep up, many financial firms have split the responsibilities for financial crime and other conduct compliance areas to separate internal units, but those UK practitioners preparing for the Consumer Duty have a busy time ahead of them, Spiers explains.

“The largest challenge for many UK-focused firms at the moment will be the uplift required by the Consumer Duty,” Spiers adds. “This is a large piece of work for firms and will require an assessment phase followed by, in some cases, substantial investment in data and management information capabilities to ensure that the firm is achieving consistently good customer outcomes over the product, service, and client lifecycle.”

Fight for talent

Perhaps the most insidious problem facing financial firms’ compliance functions cannot be solved by chucking money at it, even if firms were willing to. There is an international dearth of high-quality professionals — especially those who combine compliance and rare technical skills. These specialized professionals are in growing demand as the function’s involvement in areas such as digital security, ESG, and crypto-finance increases.

“Compliance teams are facing heavy and increasing workloads, with a scarcity of some very technical skills in areas such as sanctions,” Salmond says.

Skills shortages also affect efforts to make compliance more efficient by using more regtech and AI, because the experts that can bring that efficiency are in high demand across much of the economy.

“The fight for talent runs across the entire ecosystem,” Salmond says, adding that traditional financial institutions, fintechs, technology vendors, and consulting firms are all competing heavily for suitably skilled staff.

Firms should also not expect regtech and AI in themselves to be an instant solution that slashes the need for expensive compliance headcount. Many technology packages have been available for years and most provide a “digital compliance framework” comprised by a range of tools, the majority of which require human input, Spiers notes. “Making compliance easier, achieving good client outcomes, and reducing financial crime at scale requires data and tools to analyze the business — and the interaction of people with the existing technology tools in the digital compliance framework is key.”

Further, like many change projects, adopting new compliance technology puts additional strain on teams in the short term and requires careful planning to implement effectively. Although compliance consulting firms are commonly called in to help financial firms scale up their business or adapt to regulatory changes, they are now frequently commissioned to help firms integrate technology and the human team.

“Our clients are indeed struggling with finding the balance of people and squaring the promise of elements within the future digital compliance framework with the reality of the tools available today,” Spiers says. “We are frequently called to help them implement, tune, or support elements of their digital compliance framework and augment resources to provide that human brain support.”

This article was written by Tim Hitchcock of the Thomson Reuters Regulatory Intelligence team.

“The landscape of crypto campaign contributions remains a rapidly developing area,” says Chris White, a campaign-finance specialist with the Washington DC-based law firm Wiley Rein.

In an article published on the law firm’s website in June, White and Wiley co-author Caleb Burns wrote: “As interest in the use of cryptocurrencies for political contributions has increased, states have begun to fashion their own sets of laws and regulations governing the use of cryptocurrencies in campaign finance. The approaches taken at the state level fall on a spectrum from a total ban on the contribution or use of cryptocurrencies to the explicit approval of contributions made via cryptocurrency.”

With such a rapidly changing patchwork of laws, it would be wise for professionals in this area to keep up with the legality of crypto campaign contributions.

Federal elections

A 2014 advisory opinion from the FEC gave a green light to political action committees accepting contributions in Bitcoin. Also, individual federal candidates can accept donations on the form of cryptocurrency, but the FEC prohibits using cryptocurrencies to pay for campaign expenditures.

The FEC holds that that cryptocurrencies fall under the “anything of value” catch-all areas of the Federal Election Campaign Act, which defines such contributions as “any gift, subscription, loan, advance, or deposit of money or anything of value made by any person for the purpose of influencing any election for Federal office.” Therefore, cryptocurrencies are treated similarly to “stocks, bonds, art objects and other similar items that cannot be deposited upon receipt, but will be liquidated at a later date.” The donation’s value is based on the market value of the cryptocurrency on the day of the donation.

Although the FEC specifically referenced Bitcoin in the 2014 advisory, it is presumed that the advisory would apply to other crypto assets. (The commission has a detailed guide to reporting crypto donations on its website.)

States with a green light

In addition to the FEC, Arizona, Colorado, Iowa, Ohio, Tennessee, and Washington have said contributions made via cryptocurrency are permissible.

California recently joined the list when it reversed its ban on crypto contributions after the California Fair Political Practices Commission voted unanimously to repeal the state’s ban on cryptocurrency donations and adopt new rules for accepting the funds. The new California regulation was finalized in late July and will take effect within 60 days. It requires that donations be verified via a know-your-customer (KYC) procedure and be processed through a US-based third-party payments processor registered with Treasury’s Financial Crimes Enforcement Network.

Colorado, Iowa, Ohio, and Tennessee have followed the FEC’s guidance and requirement that the donations should be fair valued at the time of the contributions, and any increases or decreases should be treated as other income or expenditure.

Conversely, Washington and Arizona are treating cryptocurrencies more like traditional forms of currency. Washington state has taken a more restrictive approach, treating crypto donations as the equivalent of cash contributions, capping them at $100, requiring them to be converted to fiat currency within five business days, and prohibiting the use of crypto for the purchase of goods and services. While Arizona stated that “committee[s] may accept an in-kind contribution in the form of cryptocurrency… and such contributions are generally subject to the same rules applicable to traditional contributions in US currency.”

“In keeping with this treatment of cryptocurrency as analogous to ‘traditional’ US currency rather than a commodity, Arizona has neither expressly approved nor expressly foreclosed the use of cryptocurrency by political committees to purchase goods or services,” explained the attorneys at Wiley in their article.

States with clear prohibitions

Only a handful of states have expressly prohibited campaign contributions via cryptos, either by law or official guidance. The decisions to ban the contributions have been driven by fears of outside influence and the volatility of the prices associated with cryptos. Such volatility could make the value of the contributions difficult to verify or ascertain.

After the reversal of the California ban, Michigan, North Carolina, and Oregon are the only remaining states in which there are explicit bans.

Gray area states

With only a handful of states expressly prohibiting or clarifying their position on crypto campaign contributions, most others remain in a gray area.

“In Illinois and Georgia, campaigns have been accepting contributions via cryptocurrency despite the lack of express official permission to do so,” according to the Wiley attorneys. “In Georgia, the executive secretary of the Georgia Government Transparency and Campaign Finance Commission has informally advised that candidates and committees may accept contributions in cryptocurrency if the recipient candidate or committee then immediately converts the cryptocurrency to traditional US currency.”

Caution advised

With such uncertainty and a rapidly developing legal landscape, there are risks and potential opportunities for donors and candidates when accepting cryptos as contributions.

As candidates seek to tap into non-traditional donors and align themselves crypto-supporting voters, they should be extra careful not to run afoul of the regulations on a national or state level. If campaigns or candidates accept crypto contributions, they must establish a thorough KYC process to document the contributions.

Campaigns or candidates should also be careful of the wildly fluctuating value of the cryptocurrencies before their conversion to dollars, particularly now as prices of most cryptos are near lows for the year.

“Prospective donors and candidates or committees should consult with counsel before making or accepting any contributions via cryptocurrency,” White and Burns wrote.

As part of the CARES Act, the federal government provided an estimated $260 billion for enhanced and expanded benefits under three new pandemic unemployment insurance benefit programs. These programs expanded the number of individuals eligible for unemployment benefits, extended the eligibility period, and also increased the benefits by $600 per week.

Unfortunately, few states were prepared to handle the influx of individual applications for unemployment benefits much less the rampant fraudulent applications made by criminal enterprises using personal information available from data breaches and purchased on the dark web. During this time, states were processing “10- to 15-times the typical volume of claims.” Within the first five months, the Labor Department reported 57.4 million initial claims for benefits.

In addition to the increased volume of claims that overwhelmed antiquated systems, states prioritized getting assistance to individuals over screening for potential fraud. As a result, millions of fraudulent applications were approved and billions of dollars in fraudulent claims were paid.

The US Employment and Training Administration reported an improper payment rate of 18.71% for 2021 in two of the three pandemic unemployment benefit programs with a “significant portion attributable to fraud.” By this estimate, at least $163 billion could have been improperly paid, according to the Labor Department.

The department identified multiple vulnerabilities that contributed to the increased fraud in these programs, including:

• • • state information technology systems that “were not modernized”;
    • staffing resources that “were insufficient to manage the increased number of new claims”; and
    • federal guidance that was “untimely and unclear.”

Fraud detection & overpayment recovery

Under the most recent program letter, the Labor Department is providing an additional $225 million to states to “support accurate reporting, as well as detection and recovery of overpayments.” Permissible uses of these administrative funds include:

• • • payment of expenses incurred for reporting on investigation and overpayment activities;
    • payment of expenses incurred to gather business requirements, program computer systems or otherwise implement tools, strategies, or solutions to detect, establish, and recover overpayments as well as processing allowable waivers of recovery;
    • hiring staff or obtaining contract services for processing overpayments and recovering those overpayments; and
    • corrections of program eligibility issues.

Although the program letter focuses on fraud detection and overpayment recovery, it also acknowledges the need for states to ensure that “eligible individuals with legitimate claims get the benefits they are entitled to when they are due.”

Attachments to the program letter detail the amounts available to each state for administrative expenses. Applications for funding must be received no later than close of business on September 23, 2022.

Labor Dept. funding provides opportunities

The unemployment fraud recovery efforts adds another burden to state employment programs, which must still process applications for benefits quickly while operating with reduced staffing. These programs also are still relying on the same IT systems that remain vulnerable to exploitation by criminal enterprises.

A full 88% of states — 44 of the 50 states — did not perform all recommended benefit payment control crossmatches, according to the 2021 Labor Department audit. Cross-verification can help states identify the most obvious of fraudulent claims, including those involving i) multi-state claimants; ii) Social Security numbers of deceased individuals; iii) claims made by federal prisoners; and iv) claims made using “suspicious and disposable email accounts.”

Investing in technology solutions and tools that can help verify beneficiary identities at the application stage can greatly reduce the payment of fraudulent claims. These solutions would allow states share data and crossmatch personal information to identify fraudulent applications.

Indeed, the Labor Department audit found that 38% of states did not perform the required recovery activities. Other technology solutions are available that can help states identify the bank accounts previously associated with fraudulent schemes that also received unemployment benefit deposits. This would create a higher probability that the state could recover improperly paid unemployment benefits.

The Labor Department funding provides a unique opportunity for states to increase staffing to alleviate some of these workload issues, or to invest in technology solutions and tools that could help them recover improper payments that were already made and even prevent future unemployment benefit fraud as well.

The sanctions have meant that many of these banks and businesses have had to expend considerable resources on getting to know their customers better so they can keep doing business with unsanctioned parties in Russia; while other financial institutions have opted to “de-risk” and avoid the country entirely, exiting account relationships and disentangling themselves from funds transfers tied to Russia.

In a new white paper, The fog of sanctions: Global banks & businesses face unprecedented challenges in applying measures against Russia, the TRRI team examines the evolving sanctions environment in several countries, including the United States, the United Kingdom, and members of the European Union. In addition to examining what each country is doing by itself and in concert with others, this paper also looks at the troubling lack of clarity and cooperation among allies in properly applying sanctions against Russia on a global basis that would arguably have the most impact. (Besides Russia, Belarus and Russian-occupied areas of Ukraine also have been targeted for sanctions.)

You can access a full copy of the white paper, The fog of sanctions: Global banks & businesses face unprecedented challenges in applying measures against Russia, here.

Indeed, Western sanctions against Russia following its invasion of Ukraine are some of the most complex economic punishments ever meted out by the United States, EU, UK and other nations. While the US Treasury Department has been pushing out reams of guidance, other governments have offered little clarity, leaving an information vacuum and major compliance challenges. As the paper explains, varying expectations among nations and a widespread dearth of guidance are making compliance with the unprecedented complexity of Russia sanctions difficult and costly. Not surprisingly, legal, regulatory, and reputational risks faced by banks and businesses have skyrocketed.

Meanwhile, US bank regulators have publicly stated that their examiners will be looking into compliance with sanctions, with the US Treasury Department continuing to offer guidance aimed at helping financial institutions avoid compliance pitfalls. Further, the EU and UK have issued broad sanctions and prohibitions on corporate services, while drawing criticisms that they have failed to provide clarity regarding regulatory expectations.

The paper also looks at the ways in which many countries are addressing gaps in their anti-money laundering and countering the financing of terrorism efforts that have been exposed by the sanctions. The invasion and resulting sanctions have as well raised scrutiny of private fund managers such as hedge and private equity funds.

Varying expectations among nations and a widespread dearth of guidance are making compliance with the unprecedented complexity of Russia sanctions difficult and costly.

With some Russian oligarchs known to be prominent investors in such funds — and some oligarchs subject to sanctions for their ties to Russian President Vladimir Putin — the need to know who is investing in a fund and what it means for compliance are challenges that virtually all private funds face.

Other complex and steep challenges with which governments and global banks are dealing because of the Russian sanctions are also detailed in the paper. These challenges — beyond the application and execution of the sanctions themselves — include everything from the rise of so-called reputation launderers that are working with Russian oligarchs to help them evade the sanctions or obscure their assets, and the problem of asset flight as more global players (both Russian and not) move their assets out of the oversight of regulatory agencies or sanction officers.

Another significant complication is that many financial services firms within the international finance and trade sectors are finding it difficult to hire financial crime compliance professionals to help meet added demands. In fact, the state of financial services firms’ compliance teams remains in worrisome condition as compliance teams find themselves lacking the resources and the talent to fully address the burdens that the new sanctions regime has place upon them.

Indeed, compliance professionals who find themselves short of desperately needed funding may wish to share this reality, and this paper, with their boards as they push for additional resources.