Pressure on both financial and ESG performance can lead to fraud – New perspectives

As the market remains volatile, the pressure on companies to demonstrate business resilience and stable profits is increasing. Facing market pressure in turbulent times, together with a short-term quarterly based focus, may drive the risk of fraud according to observers.

Discussing the 20th anniversary of the Sarbanes Oxley Act with Bloomberg1, James Park, professor at UCLA Law School pointed towards securities fraud but also ESG fraud as real risks, noting that the collapse in tech start-up valuation might even lead to new scandals comparable to Enron. Companies today can make good use of fraud theories to detect fake and fraudulent ESG claims.  

According to James Park, the Sarbanes-Oxley Act has been important with regards to the obligation to evaluate the effectiveness of the internal controls and certify no material misrepresentation in accounts, with the effect that managers are clearly encouraged to be more careful and systematic. 

Regardless of this development, companies are still pressured to commit fraud and especially so when the market outlook is uncertain. And, says James Park, when there is an ESG disaster, there is often an allegation of securities fraud.  

Earlier this year, FCG published a whitepaper on Machine Learning for risk modelling and asset classification – Applications to Environmental Social Governance discussing the widespread discrepancy among EGS ratings. With inconsistent ESG standards, the risk of fraud (or opportunity for manipulation) increases. This is also confirmed in  Managing Fraud Risks in an Evolving ESG Environment, a report by ACFE (Association of Certified Fraud Examiners) and Grant Thornton.  

The growing pressure on senior management to deliver on ESG, both externally and internally through incentive programs is driving fraud including misrepresentation, false metrics and a failure to disclose.  

Increased quality and scope of public ESG data and risk reporting is essential to maintaining market confidence in ESG measures.

Matthew Smith, Director FCG Norway 

External ESG fraud can involve the sale of ‘green investments’, selling and buying of fraudulent credits, labelling of mainstream funds as well as investment products. It is happening in the supply chain and with third parties, intendedly and similarly in relation to pressure to comply with ESG programs and associated pricing.  

In addition to the three ACFE Fraud Tree categories – corruption, asset misappropriation, financial statement fraud – ESG fraud introduces a fourth category to the taxonomy; nonfinancial reporting fraud, which includes ESG-reporting related fraud risks, such as false labelling, false disclosure or representation, false or disingenuous certification or pledges, and/or failure to disclose or report. 

Faulty or misleading sustainability claims commonly referred to as green washing, has been on the agenda for some time. By recognizing it as fraud, more scrutiny will follow. 

Going forward, anti-fraud practitioners will play a critical role in ESG programs, with the internal control environment playing an important role in preventing ESG fraud. 

Having advised financial companies on governance, risk and compliance since 2008, FCG is predicting an ESG shakedown, with a much closer involvement with credit risk and integration with overall risk management frameworks, according to Matthew Smith, Director of ESG at FCG Norway.

To address this, FCG will look to assist clients to: 

  • Design and implement frameworks including clear policies and control environments which enable precise assessment of ESG risks and their financial implications.
  • Develop new capabilities to identify, predict and manage ESG risks and associated impact, understanding potential legal consequences as well as benefits in relation to new ESG compliance requirements. 
  • Establish measurement of ESG factors based on the framework, with requirements in first and second line for successful management of ESG performance. 
  • Design and build data-driven models to allow the organization to manage ESG metrics, and to integrate ESG in the organizations reporting. 
  • Establish and manage incentives, reporting lines and decision-making mandates, data requirements and measurements including supporting processes to ensure successful delivery on ESG compliance and goals. 
  • Based on available data volume, leverage the potential of machine learning for ESG risk prediction. 

Please contact Matthew Smith or Susanne Perneby for further information:  

Matthew Smith

Director ESG

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