Podcast - Beyond Compliance: A Deep Dive into Carbon Markets Fraud and the Government's Response

Halley Townsend: Hi, everyone. My name is Halley Townsend, and I'm an associate here in Holland & Knight's Washington, D.C., office, focusing on all things energy and environmental regulatory. And I'm here today with my colleagues, Alex Holtan, who is a partner in the D.C. office focusing on CFTC regulatory and enforcement matters, and Eddie Jauregui, who is a partner in Los Angeles, focusing on white collar defense and investigations.

Just to introduce what we're talking about today. So, we saw the first federal action against fraud in the voluntary carbon market, coordinated, brought by three different federal agencies, including the CFTC, the SEC and the DOJ. Now, just to put this in a little bit of context, voluntary carbon markets are marketplaces where participants are able to buy and sell carbon offsets to offset their greenhouse gas emissions. Used to be largely unregulated, even though there was a lot of talk about how these markets should be regulated to increase participant confidence and their quality and address concerns about potential fraud in voluntary carbon markets. But starting around last year, we saw regulators such as the CFTC start to pay a little more attention to the voluntary carbon markets.

So, last summer, the CFTC announced its creation of the Environmental Fraud Task Force and released a whistleblower notice under its whistleblower program, defining fraudulent conduct that the Environmental Fraud Task Force would be looking for in voluntary carbon markets. Things like fraud in the underlying spot markets and double counting. And so this year, the CFTC also finalized the first federal guidance regarding derivatives of carbon credits related to voluntary carbon markets. And this guidance was really aimed at setting standards for quality in the markets and preventing greenwashing, or when a company makes false or misleading claims about the environmental benefits of its products or services.

And then the last piece of context I wanted to get before we really dive into the cases here is we're also seeing a rise in private litigation in addition to these federal actions. So just a couple of weeks ago, consumers filed a class action lawsuit against a gas utility based on the utility's marketing of a product that claims to offset carbon emissions from customers' natural gas use, when the gas utility is allegedly using that money to purchase offsets from dairy digesters where the offsets are low quality.

So against this backdrop, we wanted to focus today on a few of these coordinated federal cases, as I said, by three different federal agencies against a carbon offset project developer and several members of the C-suite, senior executives who perpetrated a scheme to manipulate and falsify data concerning more than 27 projects, which culminated in the developer generating about 6 million fraudulent carbon offsets. So we're at the stage sort of set. Alex, I wonder if you can give us a little bit more details about the facts of these cases and what happened.

Alexander Holtan: Sure. Thanks for that intro, Halley. I think you set the stage well. You know, the conduct at issue here was between 2019 to 2023. And as Halley said, it involved over 27 projects at a particular carbon project developer and resulted, at least allegedly, in the generation of 6 million false carbon offsets. To put that in a bit of sized context, if you will, those 6 million offsets represent 6 million metric tons of avoided carbon emissions that effectively didn't happen. So a pretty significant amount of offsets allegedly generated due to fraud. So the conduct here was really driven by the C-suite of this particular project developer. It involved the founder and CEO, the CFO and one of their senior business executives. And the project developer here was actually a longtime market participant and one with a really good reputation and an innovator, really an innovator in the space. I mean, the CEO at one point in time sat on the board of the largest carbon verifier in the world up until he departed the company in 2023. And we'll see why he did that here in a second. So this isn't a fly-by-night operation. This was a well-respected institution that for a long period of time was just a run-of-the-mill project sponsor, focusing on things like cookstove projects in sub-Saharan Africa and southeast Asia. And then something happened to change their approach. Between 2019 and 2023, they engaged in a period of rapid growth, trying to generate more and more offsets from larger and larger projects. And as it turns out, a good portion of those additional offsets that they were generating were potentially fraudulent.

So when you're looking at cookstove projects, they're really simple in concept. The idea is that the project sponsor replaces open flame or open pit fire-based cooking with a more efficient cookstove to be used by the project participant. And you essentially measure, you know, the number of cookstoves that you use over a period of time and the efficiency of those cookstoves over that period of time to generate offsets that represent the emissions benefits of using the more efficient stove as compared to the open flame. With the 27 projects at issue here, the company allegedly engaged in two basic kinds of fraud. They, well, effectively, they cooked the books in two ways. One, they falsified the efficiency ratio for these stoves. So at the beginning of a project, you test the stoves in their locations of use to determine how much more efficient they are than a particular, than an open flame cooking method. And you use that efficiency number as the grounds to generate offsets over the life of the project. In addition, the project sponsor here allegedly falsified the number of participants that were actually using the cookstove. So over the life of a project, the project sponsor needs to survey project participants to see if they are still using those, using their stoves. And, you know, allegedly those numbers were inflated here as well.

This data manipulation or fraud was done at the direction of the senior executives of the company, that the indictments and the settlement orders have numerous different examples of communications where it was fairly clear, at least from the communications that were cited, that they knew exactly what they were doing and why they were doing it. So in terms of the efficiency numbers, the company had target thresholds where they needed to get over a particular efficiency threshold in order for the project to be profitable, and in a number of cases, the CEO, CFO and then the head of the business, so to speak, encouraged people to go back and revise numbers to try to achieve the targeted ratio or to, you know, manage the data and, I'm quoting here, "if you know what I mean." So pretty quickly, your instruction from the top on how to manage their efficiency ratios, and then in other circumstances, it looked like at the company's training that their training materials actually outlined how people on the ground in the project locations should go about inflating the numbers of actual users of cookstoves as part of the data collection process.

So, it seems to be a pretty pervasive example of what not to do in terms of trying to generate a culture of compliance internally. So, it kind of begs the question why this formerly respected company suddenly changed the way it was doing business for a four-year period leading into 2023? And I think the motivating factor here was a $250 million equity raise that occurred during this period and allowed the senior executives to cash out some of their ownership interest in the company. So, you know, an interesting case in that it is the first of its kind where federal regulators are bringing a fraud action against a participant in the voluntary carbon markets. But the fraud itself is not that creative. We've seen examples even in the environmental commodities market of people falsifying data to generate, you know, credits that represent environmental benefits that never happened. You know, for example, in the early 2000s, you saw rampant fraud in the RIN market for renewable fuels, where fly-by-night operations generated basically fictitious RINs that were then sold into the market and used by used by consumers. So nothing really novel about the approach to fraud here.

What I do think is interesting, though, is the timeline and the timeline for resolution, and Eddie will get into the nuts and bolts of how the settlement is put together across the various different regulators. But if we look at how this kind of came to be, this really started in December of 2023 when an internal whistleblower at the company raised this potential fraud to the non-executive directors of the board. And in early January 2024, a special committee of the board was formed. They launched an internal investigation, which concluded in early February and resulted in the firing of the leadership team, a number of other steps which Eddie will touch on and then a decision to self-report this conduct to the regulators. And I think what happened here during the self-report was essentially the project sponsor — sorry, not the project sponsor — the project sponsor gift-wrapped the case for the CFTC, the SEC and potentially the DOJ because by October 2024, we saw the public settlement orders that came out and the indictments against the executives at issue here, which, you know, for the fraud cases that I've worked on — and I'm interested to hear Eddie's perspective on this — this is basically warp speed. It's 10 months from the start of an internal investigation at the company to a resolution of the issue, at least for the company, with federal regulators. You know, to give you some context, the last fraud case that I worked on, it was more heavily contested. There wasn't a self-report involved, but that took over three years to resolve. So this is 10 months.

I think there are a couple of reasons for the speed with which this was resolved. One was the desire to get the self-reporting credit, as Eddie will talk a bit more about that. But the other was the overhanging specter of the CFTC whistleblower program. As Hal mentioned, the CFTC in 2023 issued a whistleblower alert, essentially soliciting whistleblower tips for fraud in the carbon markets, putting, you know, this market in the forefront as an area where the CFTC was going to be investigating. So, you know, I would have to think that the board at this project sponsor was well aware of that fact that, you know, there could be, you know, at any moment the CFTC could come knocking at the door, wanting to know more about what they were doing. In addition, the whistleblower program creates an incentive for employees to tip out to the CFTC, in this case for potential monetary awards once the case is settled, and essentially sets a 120-day clock on any internal investigation. So, you put all of those pieces together, and I think the board had a strong incentive to resolve this, to resolve this quickly and, you know, to make a soft report. And I think that's perhaps me is a bit of a, you know, a legal gate here. More of the interesting aspects of the case than, you know, the details of the fraud itself.

Halley Townsend: Thanks, Alex. That was a really helpful overview of what happened and the decision to self-report and on that decision. Let's transition now to Eddie to talk about the unique settlement outcomes for the parties involved and why they were maybe a little bit unique and to just let us know a bit more about what happened here.

Eddie Jauregui: You bet. Thank you so much. So as Alex mentioned, there were multiple agencies involved here, the CFTC, DOJ and the SEC. And each one reached a different conclusion and settlement with the company and also with the individuals. Let me start first with the former CEO and the head of carbon accounting, the two individuals who've also been indicted in the Southern District of New York. Those gentlemen were indicted in NY for wire fraud, commodities fraud, securities fraud and conspiracy to commit those offenses. And obviously, that case is pending. That case was only recently filed. The penalties for those crimes are extremely high. And the term, the potential terms of imprisonment, particularly for the wire fraud and securities fraud offenses, are pretty severe. So that is outstanding. That is the approach that the Department of Justice decided to take vis-a-vis those two individuals. There was a third individual involved in this case, the chief operating officer, Jason Steele. And at the same time that the government disclosed this indictment as against these two individuals, they announced that Mr. Steele had decided to plead guilty to an information, which is just another charging instrument like an indictment, and that Mr. Steele was going to be cooperating in the investigation or I guess had been cooperating in the investigation with FDNY. So that is the approach that the government took as to those three individuals. At the same time, the CFTC filed a complaint against the CEO, also in the Southern District of New York. And they're seeking disgorgement of all of the alleged ill-gotten gains, restitution, a permanent trading and registration ban against those individuals, a permanent injunction against further violations of the Commodities Exchange Act, as well as monetary penalties, which would be assessed by the court if the CFTC prevails against the company.

There was a very, as Alex alluded to, a very interesting outcome. What the Department of Justice decided to do as against the company was essentially to completely walk away in formal terms. What they did was they issued a declination letter where they announced that they were going to decline to prosecute the company based on the company's voluntary self-disclosure. And what's interesting here, Halley, is that what the U.S. Attorney for the Southern District of New York decided to do here was to say that they were going to decline to prosecute the company based under the U.S. Attorney's office's voluntary self-disclosure policy. And under the principles of federal prosecution of business organizations and the voluntary self-disclosure policy that the U.S. Attorney's offices have is relatively recent. In the last maybe a year or so, the U.S. Department of Justice, i.e., main justice, the U.S./AUSA and a bunch of other components of the Department of Justice have rolled out these voluntary self-disclosure programs. And what they are intended to do is provide incentives for companies to self-disclose misconduct. And that's what the company in this case did. They essentially approached the department and disclosed all of their wrongdoing. And for that disclosure, the U.S. Attorney's office decided to walk away. And here's what they cited in their declination letter, which is public. They said that they were going to decline to prosecute the company based on the voluntary and timely self-disclosure of misconduct by the company, including the fact that the company truthfully and completely disclosed all criminal conduct of which it was aware, including specifically about individuals. Number two, the company's full and proactive cooperation in the matter, which is important. Number three, timely and appropriate remediation to include terminating employees involved in the misconduct and instituting appropriate compliance measures. And number four, an agreement to cancel or avoid a number of these user voluntary — Is it voluntary carbon units? I think — that is equal to the number that the company had obtained through their fraudulent scheme. So when a company does that, it's really setting itself up, you know, in the best possible way to obtain a declination. And because the U.S. Attorney's offices maintain these voluntary self-disclosure programs, the company was able to come in under that program.

So the CFTC settled, took a slightly different approach, obviously not a prosecutorial agency. It settled fraud and false reporting allegations with the company, with the company agreeing to pay a $1 million civil monetary penalty and to cease and desist from violating the applicable provisions of the Commodities Exchange Act and CFTC regulations, among other things. And then the SEC also settled with the company. And in that settlement, the company admitted to a $250 million offering fraud scheme. And the SEC cited both remediation and cooperation with that agency as a basis for that settlement. So three different approaches. To me, the most interesting one is the fact that DOJ issued a declination. And I think it is, as Alex alluded to, part of it was that the fact that the company did come in promptly, but also they did everything sort of by the book as the U.S. Attorney's office requires for a declination under the voluntary self-disclosure policy.

Halley Townsend: Thank you, Eddie. I'm wondering, one more question for you. If you could just discuss a little bit how this set of cases informs whether a company should self-report or not. I mean, hopefully no companies are in this position. But, you know, if a company is in the position where it discovers fraudulent conduct, do you think this case supports their decision to self-report? And could you talk a little bit about, you know, how common are declination letters?

Eddie Jauregui: Sure. Let me answer the first question first. So, you know, this case was very interesting to me because the chief executive officer, the chief operating officer, another executive, and a high-level executive of the company were all involved in the fraud scheme alleged. So essentially, you have, you know, the highest ranking people in the company in the fraud scheme, number one. Number two, the amount of money at issue here was very significant. Right. So as I mentioned, the SEC cited this $250 million offering fraud scheme. I mean, those are pretty big dollar amounts. I mean, the department is used to dealing with cases much bigger. But a $250 million fraud scheme is, objectively speaking, a large fraud scheme. And then the third thing that I think is interesting is that this touches on an issue that is that the Biden Administration has identified as important to the whole of the government, which is the environment. And so these kinds of things where you have the high-ranking officers of a company, a large fraud scheme on a topic that matters a lot to the U.S. Department of Justice and the entire executive branch, these are the kinds of cases that the department would typically want to pursue. Right. Partly for deterrence, and also because they are important. They are important and aligned with the priorities of the government. And yet the Department of Justice issued a declination. Why? And I think the answer to that is because, at the same time, the Department of Justice has for several years now been trying to incentivize companies who become aware of misconduct, to self-disclose that misconduct and help the government to prosecute the culpable individuals.

And so all of this was happening at the same time that the department was rolling out its various programs, the voluntary self-disclosure policy, the whistleblower policy, which the Department of Justice also rolled out and, interestingly, was rolling out at the same time that all of this investigation and self-disclosure was happening. The company was represented by two former prosecutors at Millbank who know what they're doing when it comes to engaging the U.S. Department of Justice. And so I do think that one of the reasons that the department issued a declination here is because it wanted to. Well, a, because at least from what we know from what's publicly available, right. Counsel for the company did everything that was required under the voluntary self-disclosure policy, but also to, I think, be able to show that, look, the department has these programs and policies. You should take advantage of them. And if you do, you can obtain a declination under our policy. So I think, you know, at the same time it's another way of sending a message and a signal to companies out there that if you become aware of misconduct, you should report it and there are incentives to do so. And there are some very serious consequences to not doing so if we are, if the Department of Justice learns about them later. Does that answer that question, Halley?

Halley Townsend: Yeah. Thank you so much. That declination is just the super interesting part of these cases to me. So thank you. Question for Alex. Could you talk a little bit about what, if any, changes any companies transacting in carbon offsets should make to their compliance programs? What do these cases teach those companies?

Alexander Holtan: And, you know, that's a good question, Halley, here. And I think, to take a little bit of a roundabout approach to answering that and kind of echoing Eddie's last answer with respect to the DOJ from a, from a CFTC perspective, that million-dollar fine for fraud of this size is extremely low. I mean, you see other types of fraud manipulation cases where settlements have been in the billions, if not tens or hundreds of millions. So, you know, the CFTC definitely made a definitive choice here to reward the company for self-reporting. I think the incentives that Eddie cited certainly went into that decision. And from a more CFTC-specific perspective, the current chair, Russell Behnam, has been really a champion of the voluntary carbon markets and the CFTC oversight of those carbon markets. And I think he saw this as an opportunity to send a signal to that market that there is a cop on the beat, that, you know, this type of conduct that undermines confidence in the market will not go unpunished. And, you know, you combine that incentive with the incentive to create an environment where self-reporting is encouraged and you get that million dollar fine as a result.

So from a compliance program perspective, I mean, if I was a project sponsor of some kind, I would certainly, you know, do a comprehensive review of my data development and collection policies and procedures. I would look at my training. I would look at the incentives that I create for the various different types of employees I have within the organization. Are they rewarded for good results? And if that, if that is in fact the case, how are you know, how is that reward calculated and determined? Are you creating incentives for people to falsify data effectively? I would also make sure that you are doing periodic training and specific training on, on this case. If I were a, you know, a carbon market pilot, — sorry, project sponsor — in terms of market participants that are more users or consumers of voluntary offsets, you know, I don't think a comprehensive review of your compliance program is necessary at this point. I think being aware of the fact that the CFTC is actively engaged in this market is important. You might take the opportunity to review the, you know, the use, your use of voluntary carbon offsets and the marketing claims that you may be making in connection with the consumption of those offsets to make sure that they are, you know, verifiable and they can be backed up with hard data. So if, say, the CFTC decides to ask whether your net zero claims are in fact valid or, in the more likely case, if a private litigant like the case in in Oregon that you cited, Halley, starts to poke around, that you are able to back up the environmental and emissions-related claims that you've made based on the use of offsets with, you know, valid instruments and data.

Halley Townsend: Thanks, Alex. I think that last point is really important. I don't think anybody's intention with this podcast is to scare anybody off from using carbon offsets, engaging in these markets, using the offsets to make environmental claims. It's just that last piece that Alex said right there to ensure that they're high-quality and you have the data to back up if any of these regulators start poking around. And with that, I think we'll wrap up. I just want to turn it back to Eddie and Alex to see if they have any last thoughts and maybe the forecast for the future of enforcement and the future of these markets generally.

Alexander Holtan: Well, I'll take this one first and then turn it over to you. I think looking at carbon markets specifically, there will continue to be, at least for the rest of the Biden Administration, a focus on these markets, both at the CFTC level and in other parts of the administration. I would expect to see a number of other cases settled or, you know, settled or brought to court within the next year. As you know, the fruits of the CFTC's whistleblower efforts start to come become ripe, though. You, if we see a Trump Administration, there's going to be less of an emphasis, I would anticipate, especially at the CFTC, on voluntary carbon markets. I know the current Republican commissioners there view carbon as adjacent to the CFTC's jurisdiction, maybe not part of its core mission. So, you know, outright fraud will still get prosecuted. But whether it's the CFTC or the DOJ or state prosecutors, I think is an open question.

Eddie Jauregui: I would echo much of what Alex just said, but emphasize with what he said when he said outright fraud will still be prosecuted. I do think, as I mentioned, that this area of the environment is important to this administration. It has emphasized that. But I think if the Department of Justice becomes aware of a fraud scheme, particularly fraud schemes of this size or of any kind of significant magnitude, it will pursue them, whether it's this administration or another administration. At the same time, will be curious to me is whether a new administration, should there be a change in parties, maintains the infrastructure that's been put in place, voluntary self-disclosure, whistleblower programs, etc. But I do think that DOJ will pursue the cases like this if it becomes aware of them regardless.

Halley Townsend: Thank you very much. I think that does it for our podcast today.