Thursday, July 19, 2007

GS Sustain Focus List

On June 22, 2007, Goldman Sachs launched the GS Sustain Focus List, “companies from established industries, which have been selected by incorporating our proprietary Environmental, Social and Governance (ESG) framework into long-run industry drivers and returns-based analysis and valuation in order to pinpoint structural improvement and sustainable competitive positioning.” The list of stocks is "aimed at long term long only performance with low turnover.."

The creation of the focus list and the required methodology suggest that Goldman, like other firms, has come to see the value of incorporating a “socially responsible” framework into traditional investment analysis. While we applaud Goldman's incorporation of the ten principles of the UN Global Compact into an investment analysis framework and the firms’ tacit recognition of “socially responsible” investing, we feel the firm is ethically and ethnically challenged, and that these factors may negatively influence both the methodology and the composition of the GS Focus list. We explain our reasoning below.

Ethical challenges

We question a central thesis of the report: that Goldman has developed a superior ESG evaluation tool that allows investors, thru the firm, to “pinpoint sustainability and emerging players.”

Major Wall Street investment banks have a history of manipulating financial data in order to support business activities and to maximize short term profits. Consider the following:

On April 28, 2003, every major US investment bank, including Merrill Lynch, Goldman Sachs, Morgan Stanley, Citigroup, Credit Suisse First Boston, Lehman Brothers Holdings, J.P. Morgan Chase, UBS Warburg, and U.S. Bancorp Piper Jaffray, were found to have aided and abetted efforts to defraud investors. The firms were fined a total of $1.4 billion dollars by the SEC, triggering the creation of a Global Research Analyst Settlement Fund.

On September 4, 2003, Goldman Sachs admitted that it had violated anti-fraud laws. Specifically, the firm misused material, nonpublic information that the US Treasury would suspend issuance of the 30-year bond. The firm agreed to “pay over $9.3 million in penalties.”

On April 28, 2003, Goldman Sachs was found to have “issued research reports that were not based on principles of fair dealing and good faith .. contained exaggerated or unwarranted claims.. and/or contained opinions for which there were no reasonable bases.” The firm was fined $110 million dollars.

On January 25, 2005, “the Securities and Exchange Commission announced the filing in federal district court of separate settled civil injunctive actions against Morgan Stanley & Co. Incorporated (Morgan Stanley) and Goldman, Sachs & Co. (Goldman Sachs) relating to the firms' allocations of stock to institutional customers in initial public offerings (IPOs) underwritten by the firms during 1999 and 2000.”

In the report, Goldman notes that “Corporate governance is a key focus of investors, securities regulators and stock exchanges in recent years in the wake of corporate accounting scandals.” No mention is made of the behavior noted above.

The firm, fined $119.3 million by the SEC for various crimes (see: and received a $75 million dollar New Markets Tax Credit (NMTC) award. In the NMTC Program application, firms must attest to the following:

"The Applicant and its officers, directors, owners, partners, and key employees or any other person that Controls the Applicant:

(a) have not within a three-year period preceding the date of this Allocation Application been indicted, charged with or convicted of, or had a civil judgment rendered against them for commission of fraud or a criminal offense;

(b) have not within a three-year period preceding the date of this Allocation Application been indicted, charged with or convicted of, or had a civil judgment rendered against them for violation of Federal or State antitrust statutes or commission of embezzlement, theft, forgery, bribery, falsification or destruction of records, making false statements, or receiving stolen property;

(c) are not presently indicted for or otherwise criminally or civilly charged by a governmental entity (Federal, State, or local) with commission of any of the offenses enumerated in paragraphs 10(a) and 10(b) of this certification;

(d) have not within the three-year period preceding the date of this Allocation Application been the subject of any formal investigation or disciplinary proceeding by a government agency, regulatory body, or professional association in connection with any matter; and

(e) have not within the three-year period preceding the date of this Allocation Application been found liable in any civil legal action involving creditor's claims of greater than $500,000."

We believe GS New Markets Fund - owned by Goldman Sachs Group, Inc., technically violated this certification, and was, therefore, ineligible for a NMTC award. Even if the firm was eligible to receive the award, the allocation of federal tax credits to a firm fined $119.8 million makes a mockery of penalties assessed under the SEC’s "settlement with Goldman Sachs to resolve issues of conflict of interest at brokerage firms."

From an ethical standpoint, the firm has repeatedly engaged in behavior that would cause a prudent person to question its objectivity and fairness. We note that a smaller firm engaging in similar conduct would have been severely sanctioned by the market. Goldman has escaped meaningful sanction, however.

Diversity challenged

The report states that “Employee indicators for pay, productivity and gender diversity are universal. We measure companies’ ability to attract, retain and motivate employees by assessing employee compensation and productivity, health and safety performance and gender diversity.” By measuring only gender diversity, Goldman’s ESG framework reflects a troubling racial bias and lack of true diversity. This, in turn, reflects practices at the firm: according to a study by Chicago United, Goldman has one of the least diverse Boards of any company in the Fortune 100. This lack of racial diversity, we feel, influences methodological matters governing the CS Sustain list. Given demographic trends, gender diversity is a necessary but insufficiently robust, just or fair sole criterion to use as “a proxy for companies’ ability to attach and retain highly skilled staff from all backgrounds.” This is a frankly bigoted approach to the issue that is consistent with the current global trend toward racial animus. The immigration “debate” in the U.S. and the active targeting of racial minorities for fraudulent loans are other indicators of this trend.

Origin of the approach

The report issued announcing the creation of the Focus list states that “..the poor performance of indexes such as Dow Jones Sustainability Index and FTSE4Good (both -10% since 2000) suggests that a simplified approach of picking stocks on an ESG basis alone will not lead to stock market outperformance.” We know of no major SRI/ESG mutual fund that selects stocks based on social, or ESG factors alone.

The report goes onto state that “Analysis of the environmental, social and governance issues facing companies is not new; socially responsible investors (SRI) and NGO’s have assessed companies on ESG metrics alone for the better part of three decades since the early 1970s. However, the integration of ESG with industry analysis and financial returns is a relatively new conceptual approach. SRI indices were originally designed to separate socially responsible and sustainability-focused companies from laggards on the basis of social, environmental and/or ethical screens alone; ESG analysis was separate from industrial and financial analysis.” This is incorrect on two counts. Economic development projects started or managed by Dr. Martin Luther King, like the Montgomery Bus Boycott and the Operation Breadbasket Project in Chicago, established the model for future socially responsible investing efforts. In that project King combined ongoing dialog with boycotts and direct action targeting specific corporations. Thus, assessing companies based on ESG metrics goes back to December 1, 1955, when the modern age of socially responsible investing began.

The second error relates to the integration of financial and social data. We first outlined this approach in 1991, when we created the Fully Adjusted Return™ methodology. Further, in 2001 and 2002 we participated in the SPI-Finance Project, linked to the Global Reporting Initiative and “undertaken by a group of financial institutions from Australia, Germany, the Netherlands, South Africa, Switzerland and the UK. “ We discussed the integration of financial and social performance measures for the financial services industry, based on our work creating the Fully Adjusted Return methodology.

Goldman’s work fall into this approach, first developed to aid in the selection of women and minority-owned banks, and takes it to a broader stage, but the core technique remains the same. Our concern is this: given the ethical and ethnic issues raised above, and based on our fifteen years of experience in the creation and application of SRI/ESG tools and techniques, we feel the application of this technique requires a fully objective third party, with no actual or potential conflicts of interest.

National bias is racial bias

The report discovers “country bias with regards to environmental, social and corporate governance performance.” We believe this is due to Goldman’s narrow and limited perspective on SRI/ESG issues. Excluding South Africa, no African countries are on the list. Excluding Japan, no Asian markets are included. Excluding Brazil, no Latin markets are included. Thus, areas representing the majority of the world’s population are excluded. This makes the report a non-minority (non-people of color) company and country exercise. This is consistent with the flawed diversity framework noted above. Certainly, data and capitalization issues represent a challenge, but given the firm’s reach and resources, these geographic regions could be included. Doing so sets the stage for the future and allows for a more realistic and consistent set of long term (50 year) forecasts, since at some point these regions will join the capital markets of the world.

Constructing the list

The GS Sustain Focus list contains “only companies for which we have completed our ESG analysis and companies under coverage in emergent industries.” While we believe it is important to know which companies on the list Goldman has current investment banking relationships with, a more important metric concerns Goldman’s strategic plan for future relationships. Because many of the industrial sectors and companies featured in the report are new (solar power, biotechnology) the report may be used to curry favor with potential future industries and clients. We note that being on the GS Focus list will have added value as institutional investors come to see the list as valuable. If SRI/ESG and sustainability issues have grown in importance, they have done so because they are critically important to the future of democratic capitalism and despite active opposition by most Wall Street firms, who, ten years ago, considered this type of analysis superfluous.

Action Steps

We have found these behaviors often the prelude to the development of a set of fraudulent business practices. In this specific case, we feel this may include manipulating or misrepresenting data used in ESG/social investing processes.

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