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MITIGATING THE IMPACT OF A REGULATORY INVESTIGATION

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Stephanie Homme

Stephanie Lhomme, Head of the Compliance Intelligence Investigations and Technology (CIIT) department for Europe & Africa and David Dinnell, Director CIIT at Control Risks explain what banks and the financial sector can do to mitigate the impact when the regulators arrive to investigate alleged fraud and corruption.

It is estimated that Banks in the US and Europe have paid out $128bn – $251bn in fines to regulators since 20091. These have been for a broad range of issues including Forex scandals, Libor rate fixing, money laundering, mis-selling services, breaching sanctions and complicity in massive fraud, such as the Madoff investment scandal. Authorities across multiple jurisdictions are coming together to investigate some serious suspected misdemeanours and investigations are arising from various countries and aimed at banks and financial institutions across the globe. In July, New York state regulators stated that they wanted to install a monitor inside two European banks as part of a currencies market investigation, while other European have been under US investigation for breaking money laundering rules.

When the authorities come calling, hefty fines for corruption and major fraud are not the only things banks have to worry about. Individuals could face criminal prosecution, while banks may be forced to make swingeing changes, such as replacing the entire board, which could challenge the bank’s stability and reputation.

Potential fines
In some cases, initial expectations of the level of fine likely to be imposed following an investigation into a bank’s affairs were far higher than the final payment demanded. There are a number of reasons why this may have happened. Potential regulatory fines may have been reduced as a result of the bank volunteering information and collaborating with the subsequent regulatory investigation efficiently and completely openly, possibly through a Deferred Prosecution Agreement (DPA). To do this effectively, banks need clear protocols, paper trails, reporting lines and to be prepared to share investigative findings from day one.

Stephanie Lhomme

Stephanie Lhomme

Under a DPA, a prosecutor charges a bank – this applies to organisations only, not individuals – with a criminal offence but proceedings are suspended. A bank under investigation would agree to conditions such as paying a financial penalty, paying compensation and co-operating with prosecutions of individuals. If it does not honour the conditions, the prosecution may resume at a later date. DPAs can be used for fraud, bribery and other economic crimes.

DPAs are intended to be invoked when there is no public interest in mounting a prosecution, so they would not be suitable for every circumstance. In any case, at the beginning of any investigation, banks should never assume that they could achieve any guarantee against prosecution or any undertaking that no action will be taken against them.

It is important to be able to demonstrate to the regulator that the bank took strenuous steps to address the risk of fraud and corruption. This means having measures in place such as anti-fraud and corruption protocols to monitor internal risk and an effective system to monitor what is happening within the bank. It is crucial to have an appropriate and efficient due diligence process for customers and potential customers especially politically exposed persons (referred as PEPs). It has also become important to monitor the due diligence performed – “monitoring” is key to ensuring that the bank has up to date information on its customers.

Very often, despite the bank’s best efforts to address the risk of fraud and corruption, an investigation comes out of the blue and addresses an issue the bank may not have been able to foresee. There is every chance that even the best-prepared institutions may face an investigation and these tend to fall into two camps. Criminal investigations often result in immediate arrests and confiscation of documents and data. There may be little scope for working with the authorities. Enquiries by regulatory bodies such as the Serious Fraud Office (SFO) in the UK and the US Securities and Exchange Commission may sometimes be preceded by written notice, although there is still commonly a requirement that the bank will provide information requested, whether by producing people for interview and supplying documents.

In some cases, regulatory investigations might result from a bank “self reporting” an issue. Banks are legally obliged to do this and the process of self reporting does allow them to prepare for and control the process to some degree. However, self reporting may also trigger unforeseen consequences as the information disclosed may be used in another jurisdiction against the bank. Both self reporting and DPAs can have negative consequences and it is essential to have external experts who can advise on the practicality of those approaches.

Best practice approach to investigation
There are some practical steps a bank can take to prepare to respond to a regulatory investigation and manage it effectively. Regulators like to see problems resolved quickly. Complete and unconditional co-operation is usually the best option but it is vital to seek expert support as soon as possible.

The first stop will be legal counsel (in-house and external), and advisors with the relevant crisis management, investigations (including forensics) and regulations expertise. Employees from across the bank, including technical and HR staff, may be called in to assist with the investigation. External support will be needed to ensure that staff are able to retain and retrieve documentation efficiently. A co-operative attitude, presenting key information clearly and succinctly, goes a long way here.

External experts can play a key role at an earlier, preventative stage, ensuring banks implement best practice when it comes to compliance and they can demonstrate lessons have been learned and steps taken following previous incidents or have addressed issues identified more widely within the banking sector. Once an investigation is underway, regulators will want unfettered access to internal staff but external experts can also advise or “coach” staff throughout the process to ensure the bank responds adequately to the regulator’s requests.

Banks need to show that oversight has been implemented at every level to backstop employee decision-making and prevent rogue traders and protect against other internal threats. An impartial view of the bank’s processes is necessary, ideally combined with the ability to take an expert view of business systems to audit aspects such as access control, data transparency, retention and deletion and discoverability. Even if this approach does not affect the level of fine or regulatory action taken it can, by making the whole process as efficient as possible, reduce the considerable legal bills that the banks would otherwise run up to address regulatory investigations.

References
1   http://www.huffingtonpost.com/2014/08/08/big-bank-fines-total_n_5659317.html; http://www.forbes.com/sites/robertlenzner/2014/08/29/too-big-to-fail-banks-have-paid-251-billion-in-fines-for-sins-committed-since-2008/

About the authors:

Stephanie Lhomme is Head of the Compliance Intelligence Investigations and Technology (CIIT) department for Europe and Africa at Control Risks. Stephanie has nearly 20 years of professional experience working mostly in financial and risk consulting across the world, with significant international experience in complex M&A transactions, fraud investigations and anti-corruption matters. [email protected]

David Dinnell is a Director in the CIIT department, leading the Fraud and Forensic team for Europe & Africa. David manages a broad array of complex investigations into fraud, corruption and other ethical breaches, supported by teams in Europe and Africa. He specialises in leading multi-disciplined investigation teams delivering innovative and successful investigative solutions for clients. David has over 25 years of experience working in the region and has an in-depth understanding of regional business practise and the risk environment. [email protected]

For further information visit http://www.controlrisks.com

Investing

Can Thematic Investing provide investors with growth opportunities in uncertain times?

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The impact of COVID-19 on the investment market

New whitepaper from CAMRADATA explores

CAMRADATA’s latest whitepaper on Thematic Investing, considers the role this type of investing can play in asset management and explores trends that can permeate society and traverse sectors. The whitepaper includes insights from guests who attended a virtual roundtable on Thematic Investing hosted by CAMRADATA in November, including representatives from CPR Asset Management, Sarasin & Partners, Impact Investing Institute, PwC, Quilter Cheviot, Scottish Widows and Stonehage Fleming.

Sean Thompson, Managing Director, CAMRADATA said, “In these seminal times, thematic investing has the potential to shape how the future unfolds. Yet running a successful thematic fund is no easy feat – it is a bit like navigating unchartered waters trying to identify the trends and the long-term opportunities.

“Trends such as AI and biotechnology are still in their relative early days, for example, and global economies are undergoing dramatic changes. But mapping out certain trends, identifying potential sustainable returns through a unifying thread that spans multiple sectors, could help future-proof investments. “Our roundtable guests considered current key themes, which themes worked well, and which have not and how thematic investors could identify trends with the potential to offer future growth.”

The guests named themes they currently like which included artificial intelligence, China, climate change, clean energy, automation, evolving consumption, ageing, digitalisation, water, waste management, biodiversity, and board diversity.

After discussing themes that have worked or not, the guests looked at total allocation to themed funds, and whether clients might be blinded by themes to the overall risk exposure in their portfolios.

Key takeaway points were:

  • Themes have a habit of coming and going. One guest recognised that automation and robotics, for example, were cyclical, which means that investors will have to think carefully about entry-points.
  • It was agreed that the commodities ‘super cycle’ of the 2000s came about with the economic development of China. Many commodities-based products found their way into mainstream investing, but this is unlikely to happen again.
  • One guest was surprised by some of the themes that interested their customers; with their research showing that Board Diversity was almost the lowest-ranking concern among the ESG choices they listed.
  • There was correlation between environmental impact and social benefits to investing. The theme that concerns the Impact Investing Institute, which is less than two years old, is improved measurement of such relationships.
  • In terms of successful themes, one clear winner due to COVID had been digitalisation.
  • One theme that has not done so well is the Ageing theme focused on older people travelling and enjoying experiences abroad later in life.
  • One guest said their firm used themes for ideas generation, not as a shortcut for portfolio construction. They said themes lead to good ideas, but they then spend at least three months researching a stock, so that the best themes are represented by the best investments.
  • The final point was that there are sensitivities for any global investor in allocating to themes, even the biggest one of all, Climate Change.
  • But on a positive note, one guest added if all stakeholders can resolve their differences on definitions such as impact and ethical investing, then more capital will be readily transferred into opportunities.

The whitepaper also features two articles from the sponsors offering valuable additional insight. These are:

  • CPR Asset Management: ‘Central Banks: leading the path towards Impact Investing’
  • Sarasin & Partners: ‘Theme or fad? How to invest for the long term’

To download the Thematic Investing whitepaper, click here

For more information on CAMRADATA visit www.camradata.com

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Promises, Promises: Navigating the Reputational Risks of ESG Investment Pledges

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Why are people investing in music?

By Nir Kossovsky and Denise Williamee, Steel City Re

As the trend towards ESG investment and a low-carbon economy continues, banks are being backed into a reputational corner. Law firms specializing in representing the expanding pool of litigious shareholders are salivating.

On one hand, banks understand the inherent financial risks and challenges involved with making a wholesale move towards a low-carbon economy. The transition to a greener corporate world can’t happen overnight; as long as “brown” assets continue to be profitable, those in bank leadership positions have to balance their green aspirations with their responsibility to shareholders.

On the other hand, while not renewing loans on existing coal mines or fracking sites may improve a bank’s carbon disclosures, it could have social and financial ramifications that disappoint other stakeholders—i.e., causing people to lose their jobs. Still, financial institutions are experiencing pressure from all sides—from ESG investors to social license holders – to divest the fossil fuel industry and adopt drastic “green financing” practices now.

To alleviate these pressures, banks are pledging greener financing initiatives. Almost every large global bank has made some sort of commitment. Goldman Sachs, for example, announced they would spend $750 billion on sustainable finance over the next decade. Bank of America pledged $300 billion.

Bank boards and executives likely don’t fully appreciate the reputational risks posed by the aspirational statements they’re making. They are making promises and raising expectations without the operational or governance systems in place to ensure those expectations will actually be met. Overpromising and increasing the risk of angering and disappointing stakeholders is the very definition of reputational risk.

Banks are in a unique position: integral to every aspect of our economy, well-known brands that work hard to build and retain the trust of their customers and the general public while operating in an environment of intense scrutiny by politicians and regulators at every level of government. Satisfying all the stakeholders calling for greener policies while fulfilling their responsibility to their shareholders is a demanding balancing act fraught with risk. The Business Roundtable pledge, led by JP Morgan Chase CEO Jamie Dimon, and elevating employees, communities, and the environment as stakeholders, was an attempt to strike that balance. Already, though, that pledge is being dismissed by politicians like Senator Elizabeth Warren, who characterized it as an “empty publicity stunt.”

The price of missing expectations is costly, and bank executives and board members could find themselves in a legal hot seat. Federal securities lawsuit filings alleging reputation harm from missed expectations are up 60% over last year, the third year of a rising trend.

This trend stems from SEC regulation S-K that calls for more human capital disclosures, and the Caremark decision that sets the bar for most securities litigation and makes board oversight of mission-critical corporate operations a test of the duty of loyalty. Other cases, like In Re Signet, have made ESG-like pronouncements—historically “immaterial corporate puffery”—now potentially material in the securities arena.

For example, directors’ duty of loyalty were successfully questioned in alleged failures of innovation (In Re Clovis Oncology, Inc., board failure to protect the firm’s reputation for pharmacologic innovation); safety (Marchand v. Blue Bell Creameries, board failure to protect the company’s reputation for food safety); and environmental sustainability (Inter-Marketing Group USA, Inc. v. Armstrong, board failure to protect the firm’s reputation for oil pipeline-related environmental protection).

In other words, aspirational pledges are now being considered by courts with the full weight of a material public disclosure. As wealth managers chase ESG-informed investing and capital markets chase ‘green underwriting’, the plaintiff’s bar chases boards and executives making pledges that appear to be no more than aspirational marketing.

The only way to strike a balance and mitigate these risks is through a robust Enterprise Risk Management (ERM) strategy that’s centered around understanding who your key stakeholders are, what their interests are, and ultimately, what their expectations are. Coincidentally, it is also one of the three key behaviors the world’s largest asset management firm, Blackrock, is demanding of all investee companies in 2021 thus communicating the type of authenticity to its slogan “beyond investing,” that BP failed to accomplish with similar sloganeering a decade ago.

Banks need to create a central intelligence unit with board level oversight to comb through every aspect of the organization to identify stakeholder interests, potential risks and/or exposures. Pledges and communications should be informed by a rigorous and honest self-assessment of the institution’s public filings and operational capacity. Overpromising is costly. ESG pledges must be rooted in achievable goals that a bank’s leadership are confident their institutions can reasonably execute on an operational level. Banks also need to consider transferring or financing risks using the broad range of conventional and parametric insurance products currently available.

Enterprise risk management, when executed properly, will fulfill ESG commitments, reassure stakeholder groups and give marketers, counsel, and investment as well as government relations professionals an authentic story to tell about strong corporate governance. ERM focused on reputational intelligence will provide confidence to ESG funds, institutional investors, bond raters, and government officials alike.

The popularity of ESG investment and chasing ESG ratings is not going to go away, and stakeholder pressures will continue to mount. Investors doubled the size of the ESG sector this year, putting $27.4 billion into ETFs traded in U.S. markets. According to a recent survey conducted by Bank of America relating to ‘Gen Z’—which is just entering the workforce—80% take ESG into account when making their investment decisions.

Bank leadership that is striving to attain the correct balance between stakeholders and shareholders need to lean more into the “governance” portion of the ESG equation; pledges backed by enterprise risk management are the strongest pledges you can make.

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ESG – Bubble or Bandwagon?

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Portfolios that a daring young investor may choose

By Josh Gregory, Founder of Sugi

Isaac Newton was a successful investor, but he lost a fortune (£15m in today’s money) in the South Sea Bubble of 1720. When asked about his misadventure, he supposedly replied that he ‘could calculate the motions of the heavenly stars, but not the madness of people’ (presumably, himself included). 

The rise and fall of South Sea stock was one of the earliest and largest instances of a market bubble and crash. Three hundred years later, we’re facing another massive investing trend: sustainable investing. In the last year or so, almost every investment institution has jumped on the sustainability bandwagon. 

It’s now arguably more notable to find an asset manager who hasn’t committed to sustainable, ethical, responsible, impact and/or ESG (environmental, social and governance) investing than one who has. The numbers are telling: in August 2020, assets in global ESG exchange traded funds and products topped $100 billion (£73 billion) globally. 

Demand for sustainable investments has been bolstered by two main factors. Firstly, with climate change firmly on the global agenda and all eyes watching the Biden administration’s transition to power (and the subsequent climate change policy that will follow), ‘greening up’ has never been more of a priority for businesses and individuals. This includes the investment industry, with both retail and institutional investors increasingly demanding that their money has a positive impact on our planet. 

Secondly, since the start of the COVID-19 pandemic reports have continually claimed that ESG funds are outperforming ‘traditional’ investments. No longer is going green cited as a ‘nice to have’; rather, these reports demonstrate the value and resilience of ESG funds to the investor community, increasing demand. Surely, this can only be a good thing? Yes, but only if investors know what they’re buying. 

It’s no secret that ESG investing suffers from complexity, lack of transparency and a lack of any universal standard. Fundamentally, this is why we created Sugi – a new platform enabling retail investors to track the environmental impact of their investment portfolios using clear and objective carbon impact data. 

Josh Gregory

Josh Gregory

Today, ESG terms can lawfully be used to label pretty much anything. Ultimately, this means that the ESG label is not a guarantee of good practice. In fact, an ESG rating is a financial risk metric – the scores calculate the extent to which ESG issues affect a company’s economic value. Many investors, even institutional investors, don’t know how to decipher this. The scores themselves are designed to be used in tandem with portfolio dashboards and other data to make financial decisions. This effectively means that the scores on their own without any context are not of much use to anyone.

This has led to a glut of greenwashing in the sector, where investment products are described as green, ethical or sustainable, but the description is unsubstantiated. And while the top financial performance of ESG funds seems uncontroversial, those digging a little deeper may be surprised at what they find. Many ESG funds are heavily weighted in favour of technology companies, which typically have low carbon emissions. These stocks skyrocketed in 2020 but it’s important to note the context. It was largely due to the COVID-19 lockdowns and had nothing to do with the stocks’ ESG credentials. 

The EU, the UK and the US are all working on their own strict definitions of ESG. This should, in theory, go some way to clarify what investors are getting when they choose an ESG or sustainable investment product. However, this will take a while to implement and there will still not be a globally recognised definition or standard. 

It would seem many people are pouring money into investments when they don’t know what they’re buying. That’s nothing new. But underneath the ESG label lies something meaningful, worthwhile and, above all, valuable for the world in which we live – environmental, social and governance best practice.

The question remains though, is it a bubble? A bubble exists if ESG investments are over-valued (i.e. over-bought). Right now, ESG funds may be in bubble territory because many of the underlying stocks that make up the funds are themselves in a bubble. But does that make ESG a bubble? If it is, when do we call it? 

Historically, all bubbles –whether they be tulips, canals, railways or the internet – no-one knows. And if I knew now, I’d be sunning in the South Seas rather than writing this blog!

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