Last Friday, the SEC released a risk alert providing observations of deficiencies, control weaknesses, and effective practices related to environmental, social and governance (ESG) investing products observed in examinations of investment advisers and private funds. The observations largely fell into three categories that the SEC indicated its future examinations of firms engaging in ESG investing will focus on: (a) portfolio management - including policies, due diligence, and proxy voting processes, (b) marketing and public communications, and (c) compliance programs.
SEC staff observed that some firms made inaccurate or misleading claims about ESG investing capabilities, adherence to global frameworks, and proxy voting policies. The risk alert describes related issues such as ineffective or absent policies and procedures, weak or unclear documentation, and inadequate compliance oversight of ESG investing claims and sub-advisors. Contrasting effective practices highlighted in the alert include clear, precise and tailored disclosures that reflect actual practices, detailed ESG investing policies and procedures, and compliance personnel that are integrated and knowledgeable about ESG investing claims.
Also, on Wednesday, the Basel Committee on Banking Supervision (BCBS) published two reports on Climate-related risk drivers and their transmission channels and Climate-related financial risks – measurement methodologies. Together, the reports provide a foundation in the mechanisms for climate-related risks to the financial system, methods for measuring those risks, and an overview of supervisory actions in this area. In the US, it was reported yesterday that the Biden Administration will soon issue an Executive Order (EO) instructing a wide range of agencies, including the financial services regulators, to evaluate climate risks in their sectors and take steps to combat them through supervision and regulation.
Shortly after the SEC announced that it will step up enforcement of ESG claims and disclosures, it has provided some transparency and insight into the types of issues examiners will scrutinize. While the alert contains a wide variety of issues and effective practices, they all share a clear underlying principle: firms shouldn’t make ESG claims that they can’t back up with actual practices and policies. Accordingly, firms offering and advertising any level of ESG investing should make sure that they have documentation and data to demonstrate the veracity of their claims. In doing so, they should also be transparent and accurate about exactly what they - or their ESG-focused sub-advisors - are able to offer. As the alert indicates, firms will be less likely to have mismatches between their ESG claims and practices if they train and empower their compliance staff to scrutinize them.
The upcoming climate risk EO will mark another advance in the Biden Administration’s campaign to mitigate the effects of climate change. As we have previously described, many of the financial regulators have already started to take action on climate risk and the EO will provide authority and impetus to go further and potentially issue new requirements. For firms preparing to measure and manage climate-related risks in their own operations before they are formally required to do so, the recent BCBS reports provide a valuable and comprehensive overview of climate risk concepts that can serve as a foundation for upskilling risk management and compliance staff.
On Wednesday, cryptocurrency platform Coinbase - the largest such platform operating in the US - went public through a direct listing on Nasdaq. Coinbase’s direct listing comes at a time when the cryptocurrency market is surging with rapidly-growing M&A and fundraising activity. Last year saw the total value of crypto-related M&A activity more than double the total from 2019, and it is expected to continue its pace this year. Also this week, Fed Chair Jerome Powell said in an interview this week that he views cryptocurrency as vehicles for speculation as opposed to a form of payment, comparing digital assets to gold rather than currency.
Just four months into 2021, it has already been a big year for the mainstream adoption and development of cryptocurrency, with major banks and payment firms announcing their support for crypto as well as the surging market capitalization of digital assets. While Coinbase’s public offering is a sign that the floodgates may open to further cryptocurrency market participants going public, Chair Powell’s comments serve as a reminder that the regulators are taking notice. Regulatory uncertainty has been cited by other major cryptocurrency platforms as a reason preventing them from pursuing public offerings or even operating within the US. With Gary Gensler confirmed this week as SEC Chair, some in the industry (as well as at least one SEC Commissioner) have expressed optimism that his recent background teaching cryptocurrency-related issues at MIT will translate into the development of a clearer regulatory framework. Increased regulatory clarity will inevitably come with increased scrutiny, however, and firms should be aware that the regulators will be watching closely to ensure that market participants meet their expectations for issues such as investor protection and anti-money laundering.
For more, see PwC’s 2020 Global Crypto M&A and Fundraising Report.
On Wednesday, the New York Department of Financial Services (NYDFS) announced an enforcement action against an insurance company related to alleged defects in its cybersecurity program. Specifically, it alleged that the company failed to implement multi-factor authentication (MFA) as required by NYDFS’s cybersecurity regulation (i.e., Part 500), resulting in multiple successful phishing attempts that potentially compromised customers’ personal data. It also explained that, while Part 500 permits firms flexibility in implementing alternative control to meet certain requirements including MFA, the company’s measures to secure its email accounts fell short of the “reasonably equivalent or more secure controls'' required by the law. Further, the NYDFS alleges that although the company reported two of these incidents as required by Part 500, it failed to report two other similar cybersecurity incidents. It also notes that the company certified compliance with Part 500 as required by the law, but due to the defects in its program its certification was false.
The announcement of the enforcement action came one day before the April 15 annual deadline for companies to certify their compliance with Part 500. The NYDFS issued its first enforcement action under the law last year.
The seeds planted by former prosecutor NYDFS Superintendent Linda Lacewell in her enforcement-focused reorganization of the agency have borne fruit. Coming on the eve of the required annual certification, the NYDFS’s announcement serves as a warning shot for firms that might have been considering certifying without meeting the requirements of Part 500. Specifically, the failure to adequately implement MFA, which was widely viewed as a significant technical challenge, should caution firms that the DFS is truly holding firms to a high standard, both with implementation as well as with respect to alternative controls. The final Part 500 was ultimately more flexible and risk-based than earlier proposals, but this week’s action underscores that this flexibility is not a license to slack on the rule’s more challenging requirements. If a firm does choose to use alternative controls, it should have clear documentation that they were designed in conjunction with a risk assessment and approved by the Chief Information Security Officer.
On Thursday, the House Financial Services Committee (HFSC) Subcommittee on Investor Protection, Entrepreneurship and Capital Markets held a virtual hearing on the end of LIBOR. Lawmakers heard testimony from representatives of the Fed, Treasury Department, SEC, OCC and Federal Housing Finance Agency. Addressing the risks associated with legacy LIBOR contracts without or containing inadequate provisions to address LIBOR’s permanent cessation quickly became a focal point of the hearing.
Fed Chair Jerome Powell, Treasury Secretary Janet Yellen and a number of industry groups have voiced their support for legislation at the federal level. A draft of proposed legislation, titled the “Adjustable Interest Rate (LIBOR) Act of 2021” has now been made public by the HFSC. The bill is modeled closely after a legislative solution put forward by the Alternative Reference Rates Committee (ARRC) in New York State, which was only recently signed into law by Governor Andrew Cuomo. Similar to the bill enacted in New York State, the legislation would allow for the statutory replacement of LIBOR references in contracts containing no, or insufficient, contractual provisions to address LIBOR’s permanent discontinuation. Federal legislation would also allow for addressing issues associated with other, existing federal laws, such as tax laws and the Trust Indenture Act of 1939. In fact, the draft presented as part of the hearing includes provisions that seek to limit potential conflicts with such laws.
The hearing commenced with an energetic opening courtesy of Subcommittee Chair Brad Sherman (D-CA), who did his best to interject some levity into a technical topic of high importance for the financial industry but one providing admittedly limited opportunity for political point scoring. The subsequent testimony of regulators and questioning by lawmakers offered little in terms of new information with the agency representatives once again confirming that the transition from LIBOR ranks high on the list of supervisory priorities.
What did become clear is that a federal legislative solution for hard to amend legacy LIBOR contracts is gaining momentum fueled by bipartisan support. There are clear advantages to a federal bill, which can address a number of potential conflicts. We expect industry organizations, agencies and market participants alike to continue their vocal support of the bill, which at this point seems to have very few opponents, if any. Of course, nothing in politics is certain. Momentum or not, market participants should continue to view a legislative solution as a risk mitigating backstop of last resort, rather than a transition strategy. The prospect of the bill becoming law doesn’t erase the advantages of a proactive transition wherever possible, beginning with the ability to retain control over the economic outcome of amending or renegotiating a contract. Further, federal legislation, while far reaching, would be limited to contracts governed under US law, leaving parties to USD LIBOR contracts subject to other jurisdictions without this particular seatbelt.
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