Home Enterprise Software News The Relationship Between ESG and Fraud

The Relationship Between ESG and Fraud

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On the surface, ESG reporting is a perplexing process with some self-reporting shenanigans going on. Even more troubling, actual criminal, fraudulent funds have come to light. The regulatory road has taken a few turns in the right direction in terms of enforcement, and there are positive signs coming from the oversight function. Most importantly, there is hope on the horizon with help from new advances in ESG related innovation.

Gordon [1] did a wonderful job of explaining the difference between ESG, SRI, and impact investing. In short:

· Environmental, social, and governance (ESG) focuses on the ESG practices of the company’s operational performance, considering its risk profile, where the goal is driven by the organization’s financials;

· Socially responsible investing (SRI) focuses on the political views and values of the individual investor. Here, the goal is ethical in nature. All SRI funds have an element of ESG within them; and

· Impact investing means that the fund seeks very specific, positive outcomes from its investments. By investing in a company, the fund seeks to fulfill specific goals that have larger benefits not tied to financials; these are generally things that improve quality of life or the environment in some fashion. For investors engaging in impact investing, positive financial outcomes are nice, but the ultimate goal is positive change, even if it comes at the expense of returns.

ESG Transition Risk

How do boards of directors and CFOs help companies transition towards a more sustainable world? The risk to companies in a move towards sustainability arises when as their business model changes, pressure falls on their financials through aspects such as:

· changes in revenue streams;

· giving up existing contracts because their vendors don’t want to become sustainable;

· making different investments choices, like turning down equities that increase carbon emissions;

· shifts in hedging decisions;

· modifications to operational performance;

· implications to stock issuances; and

· challenges to their ability to maintain good business management through the transition.

As a result of this turbulence, the companies’ financials are going to come under pressure. In addition to these impacts, GRESB [2] highlights other transition risks such as “policy and regulatory risks, technological risks, market risks, reputational risks, and legal risks.”

As this happens, it’s less about asking, “Do they have an aggressive low-carbon agenda?” (which is valid) and more about, “Can they move their financial model to the next place?” The real question is, “How does their CFO effectively manage them through that high pressure period?” Since everyone is essentially going through this transition at the same time, it creates ripples of pressure and uncertainty in the market.

This leads to the next issue of, “How do they then begin to disclose their support of these changing, green initiatives?”

Perplexing Process

Many well-meaning organizations are confused by how to answer the questionnaires given to them by ESG rating agencies. This lack of understanding has led to inaccuracies in reporting, albeit without any malintent. Often, they underreport without even realizing it, hurting their standing in the market when compared against their peer group. Not every company has an in-house expert that can truly understand how best to answer those questions accurately and completely. While there are some long-standing professional services companies with subject matter experts that can be hired to assist, there aren’t enough to cover the entire marketplace.

Then, there can be issues when a company doesn’t utilize a rating agency, self-reports, and publishes their own public facing sustainability report. There are so many different sustainability framework systems with very little consistency between them. While some hold a specific aspect as being of great importance, others rank that same element with a very low significance. There are varying degrees of sophistication between the myriad of frameworks to choose from. Some entities are taking advantage of this by stretching what is ethical and even worse, deliberately gaming the self-reporting system. They do this by calculating their own ESG scores, using all of the available frameworks, comparing them side-by-side, then publishing the final score that produces their most favorable outcome.

Self-Reporting Shenanigans

Another challenge stakeholders face is when unscrupulous organizations are just flat-out manipulating their results and issuing a public report that has no reasonable basis in fact whatsoever. This is like issuing an attractive annual report with numbers generated by a spinning wheel. Whatever high number it lands on is what gets published. “Greenwashing is the process of conveying a false impression or providing misleading information about how a company’s products are more environmentally sound. Greenwashing is considered an unsubstantiated claim to deceive consumers into believing that a company’s products are environmentally friendly” [3].

Alexis C. Bell, the Founder & CEO of Fraud Doctor LLC®: “Having been paying attention to the latest advances in ESG, like the most recent sandbox from the Financial Conduct Authority (FCA) and City of London Corporation (CoLC) [4], there are some exciting solutions on the horizon that will help interested parties better verify the environmental (“E”) claims in an ESG report. I was really impressed by the interesting and incredibly useful innovations being developed in this space.”

Fraudulent Funds

Unfortunately, it’s not only unscrupulous organizations conscious investors have to worry about. With the rush to create “green” funds to ride this ESG wave in capital markets, following fraud patterns of the past, there have already been cases of deceptive fund names. These fund names have been designed to mislead the potential investor into believing that the underlying securities have high ESG scores, particularly with emphasis on the environmental (“E”), sustainability portion.

For example, the U.S. Securities and Exchange Commission’s (SEC) first ESG related case [5] was against BNY Mellon Investment Adviser, Inc. where they found that from July 2018 to September 2021, it was “represented or implied in various statements that all investments in the funds had undergone an ESG quality review, even though that was not always the case. The order finds that numerous investments held by certain funds did not have an ESG quality review score as of the time of investment… BNY Mellon Investment Adviser, Inc. agreed to a cease-and-desist order, a censure, and to pay a $1.5 million penalty” [6][7].

Regulatory Road

There has been some positive movement on the regulatory enforcement highway. The SEC launched an enforcement Climate and ESG Task Force, notably with enforcement actions dating back to 2008 [8]. In May, the SEC proposed amendments to update the Investment Company Act “Names Rule” to require “ESG or another specific type of investment in their names are investing at least 80% of their asset value in that strategy, rather than being misleading or deceptive” [9]. In the first trial of 2022, the Serious Fraud Office in London secured the convictions of the two company directors from Global Forestry Investments who deceived 2,000 investors out of ₤37 million in investments. The case was first announced back in February of 2015. The company directors claimed their so-called green fund helped the Amazon rainforest and supported local communities, when the money actually lined their own pockets [10].

Regulators are reacting and trying to catch up, but at the moment the global regulatory oversight function is falling behind. The lack of clear requirements and varying guidance in each country has added to these challenges [11]. This poses a compliance problem for multinationals when there are differing requirements originating from the countries in which they operate. It is Fraud Doctor’s hope that the upcoming international standards for ESG disclosures will have a similar adoption to that of international accounting standards. Here, most countries adopt verbatim the accounting standards set forth by the International Accounting Standards Board (IASB) that develops and approves International Financial Reporting Standards (IFRSs).

Hope on the Horizon

All of these issues pose challenges for stakeholders when attempting to interpret an organization’s ESG scores, or green funds that may or may not actually be green. However, even with these challenges, there is cause for optimism. Regulators are trying to do the right thing and avoid the mistakes of the past with market oversight. There are tech companies that are ingesting hundreds of external data points to objectively calculate an ESG score for a company. The field is improving. Data quality and availability is getting better.

For example, Šóta Signal Analytics™ has made advances in the governance (“G”) segment of ESG with reporting veracity. The phrase “reporting veracity” means discovering the risk of inauthentic financial reporting. This is an important, objective measure of the risk of material misstatements for a publicly traded (listed) company. By analyzing the original corporate filings, Šóta provides a risk score for the uncertainty within stated company financials and the potential of a future material misstatement. While misstatements can originate from many legitimate reasons, their focus is on the two aspects that generate the greatest amount of uncertainty: fraud (intentional) and mismanagement (unintentional). Both are symptoms of a broader, sometimes systemic, governance issue.

Many of the current external measures of governance involve using artificial intelligence (A.I.) to identify controversies from news articles. This is a lagging indicator. Once something hits the news cycle, it has already happened. While important to know, that alone does not tell the entire story. Šóta Scores™ are leading indicators, an early warning of risk. When placed next to news controversies, the full picture becomes even clearer.

Another existing external measure of governance involves web scraping to attempt to glean some understanding of a company’s overall fraud risk. However, analyzing what is essentially an organization’s marketing material is insufficient as inputs into a fraud risk model. Rather, they believe the most comprehensive and reliable way to evaluate the “G” in any ESG framework is to examine the financials. Numbers don’t lie.

When what investors care about the most is the environmental aspect of ESG, governance is a key measurement. This is because, from experience, they know that when organizations are disingenuous in one area of the business, there is a high likelihood they are also not being transparent to the public in other areas as well. Do people honestly think that when a company is manipulating earnings (a significant governance failure), they will be 100% truthful about their environmental impact from operations? Understanding a company’s material misstatement risk for both fraud and mismanagement is key to the trustworthiness of that organization. Let’s face it; the environment is too important to not have trust in the companies that receive investment.

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