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Cracking Down on a Wall Street Trend: E.S.G. Makeovers

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In early 2018, Goldman Sachs gave one of its decades-old mutual funds a makeover.

It had been invested in the stocks of large European and Japanese companies across many industries, but suddenly it became the Goldman Sachs International Equity ESG Fund. Its new investing mandate: choose foreign companies with the best reputations on environmental, social and governance policies.

E.S.G.-fund makeovers have become the trend du jour on Wall Street: BlackRock, J.P. Morgan, Morgan Stanley, HSBC, WisdomTree, Putnam and MassMutual have all done it. Over the past five years, about 90 mutual funds and E.T.F.s have undertaken similar revamps, according to the mutual fund rating firm Morningstar. And Wall Street firms have started up hundreds of brand-new E.S.G. dedicated funds — seeking to cash in on growing investor demand for such investments.

Overall, there are currently 588 sustainable funds and E.T.F.s in the United States, according to Morningstar — an increase from 203 in 2017. The assets in them have grown to $296 billion from $70 billion.

But what may have seemed like a harmless marketing move is now causing some eyebrow raising: Securities regulators are starting to question whether their do-gooder claims are real or fraudulent, at the same time that regulators are seeking to enact new rules and guidelines for what constitutes an E.S.G. investment product or strategy.

S.E.C. expands its crackdown

It’s the Wall Street version of a truth-in-advertising crackdown, and it’s a focal point for a special E.S.G. enforcement task force set up last year by the Securities and Exchange Commission. The task force is essentially looking for instances of banks and money managers engaging in “greenwashing” — using misleading claims to make their investment funds or strategies appear to be E.S.G.-compliant.

Goldman is among the fund managers the task force is investigating, though it is unclear which of the bank’s funds are drawing scrutiny. A person briefed on the matter said regulators were focused on two of its eight E.S.G. funds in the United States with about $750 million in assets.

The task force has gotten off to a slow start — bringing just two enforcement actions this year. But securities defense lawyers expect the pace to pick up in the coming months.

The investigations come as some Republicans have charged the S.E.C. with promoting “woke capitalism” while some sustainable investment proponents have begun to question whether Wall Street’s endorsement of E.S.G. is anything more than virtue signaling. Many of these money managers are accused of not making any notable sustainability efforts but instead simply shifting asset allocations away from certain industries, such as oil and gas, and into tech stocks.

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This is what happened, to some degree, inside Goldman’s International Equity ESG Fund. In 2017, before the fund was rebranded an E.S.G. product, tech stocks made up around 3 percent of its allocations. By the end of 2018, their share in the fund had more than doubled — to more than 8 percent, according to Morningstar. Out were stocks such as Japan Tobacco and Royal Dutch Shell.

A Goldman prospectus for the revamped fund says it avoids companies that “derive significant revenue” from alcohol, gambling, tobacco, pornography, guns, for-profit prisons and oil, gas and coal.

But not all E.S.G. funds avoid the oil and gas sector. A number of E.S.G. funds, such as the DWS ESG Core Equity Fund, have sizable allocations to shares of Exxon Mobil, in part because the energy company gets relatively high marks for worker pay and promoting diversity in hiring.

The PIMCO Total Return ESG Fund, which was rebranded by the giant bond mutual fund company in 2017, has a similar mix of government bonds as does the firm’s well-known PIMCO Total Return Fund and shares the same management team. Both funds have significant dollars invested in bonds issued by Fannie Mae, the federally backed mortgage finance firm, according to Morningstar data. The E.S.G. fund has a higher percentage of investments in corporate bonds.

Many fund managers make decisions on which stocks to invest in based on a company’s E.S.G. rating, which is often generated by big financial research companies. But even those ratings don’t necessarily reflect how good a company is for the world at large — it is often a measure of a company relative to its competitors.

Earlier this year, the S&P 500 ESG Index, a listing of companies that meet certain environmental, social and governance standards, removed Tesla, citing the way the electric carmaker handled accusations of racial discrimination at its factory in California.

But even those ratings don’t necessarily reflect how good a company is for the world at large — it is often a measure of a company relative to its competitors.

“Do I think there’s confusion on that front? Yes,” said Ken Pucker, a former apparel company executive who is now a senior lecturer at the Fletcher School at Tufts University.

Mr. Pucker said that even if fund managers meant no harm, their funds could be inadvertently preventing real changes from taking place.

“I worry that the growth in E.S.G. investing helps defer necessary conversation and action on planetary welfare,” he said.

Even academic researchers with strong ties to Wall Street are skeptical.

George Serafeim, a Harvard Business School professor who has urged companies and investors to double down on their focus on E.S.G. principles, is a paid adviser to several fund managers and Wall Street firms selling E.S.G. products, including the giant bank State Street and the investment banking stalwart Neuberger Berman.

In his book “Purpose and Profit: How Business Can Lift Up the World,” Mr. Serafeim says he offers “ways that companies can design and implement a strategy that has more positive impact.”

But he said there was plenty to criticize about E.S.G. funds.

“Many E.S.G. funds are doing very little of anything in fact, as they are quasi-index funds with minor tilts and with no engagement/stewardship capabilities,” he wrote in an email to The New York Times.

“In fact, in my opinion, eventually there should not be any E.S.G. funds,” he said. “E.S.G. analysis should be part of good corporate and investment management.”

‘All E.S.G. funds are not the same’

The focus by regulators on allegations of greenwashing on Wall Street is no surprise given that Gary Gensler, the S.E.C. chairman, has made regulating E.S.G. investing a top priority. He has pushed for a rule that would require Wall Street investment firms to give investors more information about how they are carrying out any E.S.G. strategy. Another S.E.C. proposal would require any fund that calls itself “socially responsible,” “sustainable,” or “green” to invest 80 percent of its assets in ways that are consistent with that strategy.

In an investor bulletin, the S.E.C. cautions investors, “You should know that all E.S.G. funds are not the same. It is always important to understand what you are investing in.”

BlackRock, the single largest manager of E.S.G. mutual funds and E.T.F.s in the United States, said in a statement that it generally supported efforts to combat “greenwashing” and “increased corporate reporting on sustainability issues.” Matt Kobussen, a BlackRock spokesman, said, “Greenwashing is a risk to investors and detrimental to the asset management industry’s credibility.”

But in a letter commenting on the S.E.C.’s proposed investment adviser rule, BlackRock raised concern that the proposal could lead “to the disclosure of proprietary information” surrounding a money manager’s ESG investment process.

Alyssa Stankiewicz, associate director of sustainability research at Morningstar, said the standards for what constitutes an E.S.G. fund were still evolving. But she said the S.E.C. was right to expect investment advisers to be consistent about the standards they claim to be using.

Dennis Kelleher, chief executive of the nonprofit Better Markets, who served on President Biden’s financial policy transition team, said the S.E.C. rules, if enacted, should help bring some agreed-upon definition to an area of investing that “lacks legal content and clarity.”

To some degree, the task force is starting to do that with enforcement actions.

In May, the S.E.C. and the task force reached a settlement with Bank of New York/Mellon after regulators found the bank did not live up to its promise to perform an adequate “E.S.G. quality review” on some of the mutual funds it advises. The bank neither admitted nor denied the allegations but agreed to pay a $1.5 million fine and changed some of its procedures.

Last year the S.E.C. opened an investigation into allegations of “greenwashing” involving E.S.G. funds marketed by DWS, the investment management arm of Deutsche Bank.

Earlier this year, lawyers working with the task force issued a number of requests to several banks seeking information about their securities lending businesses and ESG strategies, said two people briefed on the matter.

Securities lending is an activity that is closely tied to short sellers — investors that often bet on a stock falling in price. Some market analysts and academics have questioned whether lending shares to short sellers is fundamentally inconsistent with promoting E.S.G. investment strategies.

But there are concerns the task force may be moving too fast.

“Enforcement may have gotten ahead of rule-making on E.S.G.,” said Marc Elovitz, head of the investment management regulatory practice group at Schulte Roth & Zabel, a law firm that represents many big hedge funds and investment advisers. “If there is actual fraud then the S.E.C. can shut it down. But the difficult policy discussions around E.S.G. investing shouldn’t be pre-empted by enforcement.”

Daniel Hawke, a securities enforcement lawyer with Arnold & Porter and a former head of the S.E.C.’s market abuse unit, said regulators were “under significant pressure to be seen to be doing something” given the importance of E.S.G. to the Biden administration.

The S.E.C. enforcement lawyer overseeing the new task force rejects the criticism that it is overreaching.

“An investigation into possible misstatements in the E.S.G. space is really no different than an investigation into any other types of misstatements we may be looking at,” said Sanjay Wadhwa, the deputy director of enforcement who leads the climate and E.S.G. task force. “We’ve had prior actions in this space. To me, this is just plain vanilla enforcement.”

What do you think? Should Wall Street regulators expand their crackdown on E.S.G. funds? Let us know: dealbook@nytimes.com.

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