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

Fiduciary duties & non-pecuniary factors

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

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

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

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

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

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

ESG as boycott

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

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

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

Social Credit scores

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

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

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

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

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

On the horizon

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

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

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

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

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

Finfluencers & regulations

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

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

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

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

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

New attitudes toward investing

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

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

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

Case study of a finfluencer

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

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

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

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

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

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

The future

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

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

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

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

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.

But, how does a law firm go about calculating carbon emissions, also referred to as greenhouse gas (GHG) emissions, which is the first of many topics that U.S. regulators among others are starting to require? The process for quantifying this is known as carbon accounting.

Components of carbon emissions

The most common elements of the firm’s operations that are key to calculating carbon emissions are categorized in Scope 1, 2 and 3 type emissions.

Scope 1 emissions overview — Law firms are office-based and usually serve as tenants. Direct emissions (known as Scope 1) come from activities under control of the firm. Not surprisingly, law firms generally have smaller amounts of Scope 1 emissions. Typically, these emissions will come from any fuel and gas related to the operation of the building as well as from refrigerants (i.e., refrigeration, air conditioning) and fall into several areas of combustion:

• • • stationary (fuel and gas onsite);
    • mobile (firm-owned vehicles using fossil fuels); and
    • fugitive emissions (vapors directly released, like refrigerants, fire suppression).

Details of Scope 2 and 3 — Law firms will have most of their emissions come from Scope 2 and 3 categories. For Scope 2, indirect emissions come from purchased energy in the form of electricity, steam, heat, and cooling. Purchased electricity is the biggest emissions area in Scope 2.

For Scope 3 the most common indirect emissions are in the categories of measuring business travel, commuting, and purchased goods & services, including paper and waste. In the commuting category, some firms will include remote work by staff. Remote work emissions include emissions generated by equipment, such as lights, laptops, and other office equipment at home.

Key factors in carbon emissions calculations

Quantifying GHG emissions can get complicated pretty quickly, and this is why it is important to identify the subcomponents by Scope and focus on data collection first.

For Scope 1 and Scope 2, law firms will use their metered (or sub-metered) data, such as utility bills or purchase receipts and contracts. If they don’t have this, estimates based on square footage by region is the next best option.

For Scope 3, travel data can usually be found with the firm’s corporate travel agency or in the expense management system with purchase records. Commuting data and data related to remote work emissions can be obtained through surveys to employees.

In the area of purchased goods and services, it’s best to first try to obtain the data from the provider, but if the data is not available, using external databases, such as the data from the Intergovernmental Panel on Climate Change (IPCC), is the next best option. For water, the data can be obtained through sub-metered data or water bill. For waste, it is best to work with the building management.

Gather a multidisciplinary team for emissions data gathering & calculation

Compiling a cross-functional team within the support functions of the firm is necessary for the most efficient way to initiate and complete the data gathering process.

• • • Real estate, facilities & operations — Facilities and operations need to work with the building management to obtain critical data for utility data, water, waste, etc. The internal real estate department can be helpful as well.
    • Procurement & finance — Members in the procurement and finance function can help to view and track spending within the supply chain to gather Scope 3 data. Many positions within the procurement team now encompass the responsibility of emissions and decarbonization.
    • Technology — The firm’s IT group also play a role in emissions management by providing more insights on data centers, energy usage, life-cycle assessments, etc. from the procurement and e-waste perspectives.
    • Human resources — HR has a critical role to play in obtaining commuting data, sending out surveys, helping to determine remote work emissions, and other items related to the workforce.

Doing the calculation

Combining the carbon emissions is the next step once the Scope 1, 2, and 3 data sources are collected. The challenge in this step is understanding what emission factors to apply — not surprisingly, this is the point when some organizations choose to hire a consultant.

Some of the emissions factors, which is a representative value that attempts to relate the quantity of a GHG being released to the atmosphere with an activity associated with the release of the GHG, can be found on the Environmental Protection Agency (EPA) web site in the U.S., and on the U.K.’s departmental websites for the Department for Business, Energy, and Industrial Strategy; and the Department for Environment, Food & Rural Affairs. For other jurisdictions, the IPCC also has an emission factor database.

Measuring emissions will continue to evolve with the ability to gather more emission factors to create higher quality baselines. While it is important to start with the data collection, it is imperative for law firms to prioritize the biggest areas of emissions, such as travel, with low-quality data. This is where there is the opportunity for significant improvements, and law firms can refine the calculation over time.

Driving the need for continuous improvement in the calculations are the RFP requests to measure and disclose carbon emissions data from clients. Indeed, this number is likely to increase exponentially, and there will be increasing pressure for third-party verification and assurance.

An enhanced reputation is a huge benefit of carbon accounting and is a big driver to making meaningful change. Striving for this incentivizes law firms to find better ways to do things to reduce inefficiencies, waste, and consumption, which benefits everyone.

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.”

In what Fed Vice Chair for Supervision Michael Barr called an “unflinching” review of the U.S. central bank’s supervision of SVB, the Fed said its oversight of the Santa Clara, California-based bank was inadequate and that regulatory standards were too low. “SVB’s failure demonstrates that there are weaknesses in regulation and supervision that must be addressed,” Barr said in a letter accompanying a 114-page report, which also was supplemented by confidential materials that are typically not made public.

While it was the regional bank’s own mismanagement of basic risks that was at the root of SVB’s downfall, the Fed said, supervisors of SVB did not fully appreciate the problems, delaying their responses to gather more evidence even as weaknesses mounted, and failed to appropriately address certain deficiencies when they were identified. At the time of its failure, SVB had 31 unaddressed citations on its safety and soundness, triple the number its peers in the banking sector had, the report said.

One particularly effective change the Fed could make on supervision would be to put risk mitigation methods in place quickly in response to serious capital, liquidity, or management issues, a senior Fed official said, adding that such increased capital and liquidity requirements also would have bolstered SVB’s resilience.

Barr said that as a consequence of the failure, the central bank will reexamine how it supervises and regulates liquidity risk, beginning with the risks of uninsured deposits.

Regulators shut SVB on March 10 after customers withdrew $42 billion on the previous day and queued requests for another $100 billion the following morning. The historic run triggered massive deposit outflows at other regional banks that were seen to have similar weaknesses, including a large proportion of uninsured deposits and big holdings of long-term securities that had lost market value as the Fed raised short-term interest rates.

New York-based Signature Bank failed two days later (the Federal Deposit Insurance Corporation release its review of that collapse the same day as the Federal Reserve’s assessment of SVB), and the Fed and other U.S. government authorities moved to head off an emerging crisis of confidence in the banking sector with an emergency funding program for otherwise healthy banks under sudden pressure and guarantees on all deposits at the two banks.

Supervision headcount fell

Before the twin bank failures in March, banking regulators had focused most of their supervisory firepower on the very biggest U.S. banks that were seen as critical to financial stability. The realization that smaller banks are capable not only of causing disruptions in the broader financial system but of doing it at such speed has forced a banking regulators to rethink their position.

“Contagion from the failure of SVB threatened the ability of a broader range of banks to provide financial services and access to credit for individuals, families, and businesses,” Barr said. “Weaknesses in supervision and regulation must be fixed.”

In its report, the Fed said that between 2018 to 2021 its supervisory practices shifted, and there were increased expectations for supervisors to accumulate more evidence before considering taking action. The staff interviewed as part of the Fed’s review reported pressure during this period to reduce burdens on firms and demonstrate due process, the report said.

Barr signaled in his accompanying letter that this situation would change. “We need to develop a culture that empowers supervisors to act in the face of uncertainty,” he said.

Between 2016 and 2022, as assets in the banking sector grew 37%, the Fed’s supervision headcount declined by 3%, according to the report. As SVB itself grew, the Fed did not step up its supervisory game quickly enough, the report showed, allowing weaknesses to fester as executives left them unaddressed, even after staff finally did downgrade the bank’s confidential rating to “not-well-managed.”

The Fed is looking at linking executive compensation to fixing problems at banks designated as having deficient management so as to focus executives’ attention on those problems, a senior Fed official said in a briefing.

One thing the report did not do was place any blame at the feet of San Francisco Fed President Mary Daly, with a senior Fed official telling reporters that regional Fed bank presidents do not engage in nor have responsibility for day-to-day supervision of banks in their regions.

While the fallout from the failures of SVB and Signature themselves may have subsided, the ripple effects continue. The forced sale on May 1 of San Francisco-based First Republic Bank after its deposit outflows following the SVB and Signature collapses exceeded $100 billion shows that smaller, regional banks may not be out of the proverbial woods yet.

This blog post was written by Chris Prentice & Hannah Lang, both of Reuters News; with additional reporting by Ann Saphir.

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.

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.

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.