More than a year ago the world fell victim to a global pandemic that would change life in ways that could never have been predicted. In the early stages of the pandemic, we published a White Paper directed at financial markets and market participants setting forth our views on issues to consider in crisis response and post-pandemic planning. Now, one tumultuous year later, with a waning pandemic and a new administration in the United States, we again assess issues of concern and focus for financial market participants in the United States and abroad.

LITIGATION RISKS

Litigation Risk Associated with Elevated Delinquency and Default Rates

Over the past year, businesses continued to borrow money and issue high-yield corporate debt at a strong pace. Although the U.S. economy appears well positioned for a robust second half of 2021, rising interest rates and inflation, as well as the potential for corrections in the financial markets, may create risk to paying back that corporate debt. In addition, outstanding corporate and household debt continues to be at or near all-time highs. Many individuals find themselves in difficult financial circumstances with respect to repayment of housing and education loans or with other personal debts. Though foreclosure moratoriums in states including New York provided borrowers with some relief in 2020, disputes and workouts may increase in 2021 as these moratoriums expire. And even if moratoriums are extended, commercial lenders may be more inclined to seek relief on guarantees and mezzanine financing. As a result, some financial institutions and other market participants can expect to remain under increased risk of litigation due to elevated default rates and product-specific losses.

In the leveraged finance market, deterioration of corporate performance may lead to further disputes among lenders seeking priority. Efforts by some borrowers and lenders to provide incoming capital with a repayment super-priority, reducing the value of existing debt, has emerged as a focus for participants in the collateralized loan obligation ("CLO") market. Last year's pandemic-related market stress has contributed to bringing these disputes to the fore.

At the same time, commercial real estate loan performance has suffered, particularly in sectors hit especially hard by the pandemic. Although data indicates that delinquency rates have receded from their COVID-era peak, the durability of this recovery remains to be seen in some respects, and delinquency rates remain elevated in obvious categories such as lodging and retail. While commercial mortgage backed securities ("CMBS") transactions differ in important ways from the type of residential mortgage backed securities ("RMBS") transactions that remain subject to litigation more than a decade after the onset of the 2008-09 recession, litigation involving commercial loans and CMBS trusts may well continue to increase over the coming months. These lawsuits may involve direct claims by certificate holders against deal parties, investor-directed actions against obligated parties similar to those that became prominent with respect to RMBS in the wake of the last financial crisis, and claims among certificate holders in different tranches. There is also a possibility of federal and state regulatory scrutiny concerning lending and servicing practices, the ratings assigned to CMBS certificates by rating agencies, and the trading of CMBS. Already, in February 2021, the U.S. Securities and Exchange Commission ("SEC") filed a complaint against Morningstar over allegedly inflated CMBS ratings. In addition, investors have started bringing securities claims against financial institutions alleging improper origination and underwriting practices involving CMBS and CRE CLOs. It is likely similar lawsuits will follow against other financial institutions.

Consumer debt faces analogous challenges. Although there have been some bright spots in this area, such as falling credit card debt and increases in household savings, a sizable number of consumers are unable to pay their bills as they come due. Nearly three million mortgage borrowers are in some form of payment forbearance, and borrowers have taken advantage of similar programs for student, auto, and credit card debt. These programs have been buttressed by state and federal foreclosure moratoriums, as well as certain restrictions on debt collection. It remains to be seen whether consumers will be able to resume debt payments when the pandemic ends and relief is no longer available, or whether significant charge-offs are looming in the future. Substantial losses would likely have knock-on effects throughout the financial sector and could be destabilizing in many ways. In particular, consumer debt securitizations could face defaults or other stresses, leading to potential disputes among investors and transaction parties, and parties responsible for servicing consumer debt could face increased disputes with borrowers and pressure from state and federal regulators. The potential stress on any particular securitization transaction will likely be driven, at least in part, by the underlying asset class, with unsecured consumer loans or other unsecured debt potentially facing downward pressure before secured asset classes such as mortgage or auto loans.

Environmental Social and Governance ("ESG") Related Litigation Risks for Financial Institutions

ESG issues have dominated recent headlines in the financial markets, with investors seeking more ESG investment options. As a consequence, market participants are devoting ever-greater resources and assets to ESG lending and investing. ESG investing grew to more than $30 trillion in 2018, and some estimates say it could reach $50 trillion over the next two decades.

Financial institutions will be at the forefront of this change, taking on a variety of roles in the process. Indeed, they will be active as public companies themselves, as intermediaries and facilitators on financial markets transactions with other companies, and as arrangers of the ESG-compliant investment opportunities demanded by institutional and retail investors.

As we discussed in our Commentary earlier this year, ESG-related risks for financial institutions generally fall into three high-level categories: (i) risks based on their own actions and ESG-related statements and disclosures; (ii) vendor and customer operational risks, including supply chain activities; and (iii) risks based on activities as a lender, underwriter, or investment adviser.

It is worth noting here, though the issue is explored in greater detail in the next section, that financial institutions must balance dueling needs relating to disclosures: (i) demonstrating to stakeholders a commitment to ESG principles; and (ii) minimizing the risk associated with that commitment. That risk is heightened when, in keeping with investor or market demands, companies move from disclosing aspirational ESG principles to more specific and seemingly objective targets or accomplishments. Banks may also face risks as more regulators incorporate ESG issues into bank stress tests; in the United Kingdom, for example, the Bank of England is rolling out its first-ever climate-related stress test for banks and insurers following a consultation period in 2019.

Litigation and regulatory risks related to ESG are not limited to a financial institution's own operations. Financial institutions must also consider customers and third-party service providers in their supply chain; that is, whether the vendors supporting them are ESG-aligned or meeting ESG targets. For example, the Alien Tort Statute and the Trafficking Victims Protection Act could subject companies to liability for human rights violations committed abroad by customers or entities in a financial institution's supply chain. Financial institutions may also face risks from customers or their own supply chain relating to environmental pollution, human trafficking, labor disputes, and corruption.

The growth in transaction documents referencing ESG has elevated ESG as a source of risk for financial market participants in their roles as lenders, investors, underwriters, fiduciaries, and contractual counterparties, and has likewise increased the need for ESG-related due diligence. Furthermore, the developing ESG credit market has spawned the still-evolving role of Sustainability Agent-or Sustainability Coordinator-which brings with it new duties and risks. Counterparties in the new but growing market for sustainability-linked financial derivatives should take care in negotiating, defining, and agreeing to the sustainability targets that trigger various credits, discounts, or penalties in those derivative transactions. In addition, cryptocurrencies are facing heavy scrutiny and public censure for the energy consumption and greenhouse gas emissions associated with generating their tokens and implementing their protocols.

Financial institutions will also need to closely monitor the rapid increase in ESG-related pronouncements by regulators to ensure preparedness and compliance with rules that could impose new obligations on clients, counterparties, and investors alike. In this regard, the new EU Sustainable Finance Disclosure Regulation ("SFDR") came into force on March 1, 2021, and applies to asset managers, pension funds, and financial advisors. Numerous regulators in the United States have shown similar interest in addressing ESG and climate-change issues. For example, the SEC announced an Enforcement Task Force Focused on Climate and ESG Issues, the CFTC announced The Climate Risk Unit, and the Federal Reserve Board announced the Financial Stability Climate Committee. New York's Department of Financial Services, often seen as an innovator among U.S. state regulators, appointed its first-ever Sustainability and Climate Change Director in May 2020. Since then, it has continued to move quickly, providing guidance to its supervised insurers and financial entities regarding climate change and financial risk.

With increased scrutiny by regulators and investors, often supported by plaintiffs' firms, it is likely we will see an increase in fiduciary duty, derivative and disclosure-based ESG claims.

Corporate Disclosure and Duties to Update or Disclose

Disclosures by financial market participants are always ripe for scrutiny by regulators and private litigants-both with respect to private deals and public filings. To mitigate exposure to undue litigation in the current environment, issuers of

securities and financial institutions should be aware of two rapidly evolving areas of corporate disclosure risk: COVID-19 and, as noted above, ESG.

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