Companies that face a reduced risk of shareholder lawsuits because of where their stock is listed have little incentive to issue reports on their social, environmental and governance activities – despite the lower lawsuit risk – because they don’t need the “insurance” that ESG reports provide, an academic study finds.
At first glance, it would seem that a company with a lowered shareholder lawsuit risk would be confident about issuing glowing ESG reports. If their actual performance doesn’t live up to the ESG practices they tout in their reports – a growing source of shareholder lawsuits under Section 10(b) of the Securities Exchange Act, which covers misrepresentations in their public reporting – they have less to worry about from a liability standpoint.
But that reduced risk also means they don’t need the ESG reports to buff their social capital – which can act as an insurance policy to protect their stock value against bad news.
“A reduction in expected litigation costs … reduces the need for insurance and thus lowers firms’ incentive to engage in costly ESG reporting,” say researchers in an academic paper published in June by the Social Science Research Network. SSRN is an academic paper clearinghouse.
To derive their findings, the researchers compared foreign companies whose shares are listed outside the United States to those whose shares are listed outside the U.S. but also on a U.S. exchange.
Since 2010, investors who bought their shares outside the U.S. can’t sue in the U.S. if they think the company has made a misrepresentation in its public filings, even if the misrepresentation affects U.S. markets.
That has had the effect of reducing these companies’ liability for ESG misrepresentations, because fewer shareholders are eligible to sue, but the study finds the reduced risk doesn’t lead to more ESG reporting but less.
The researchers’ explanation is that the companies don’t have reason to buff their image with the reports. By contrast, if they were subject to heightened ESG misrepresentation liability, as are companies that are cross-listed in the U.S. and outside the U.S., they would find more value in the “insurance” effect of the ESG reports.
“Insurance theory posits that a positive ESG reputation builds moral capital, which offers an insurance-like benefit of preserving firm value in bad times,” the researchers say. “When an adverse event occurs, investors are more likely to give firms the benefit of the doubt and react less negatively to the event if firms have a record of treating the environment and society responsibly. Thus, firms have an incentive to issue ESG reports to protect their stock price from events that can trigger shareholder litigation.”
The findings suggest companies determine how far out on a limb to go with their ESG reporting – or whether to even include ESG matters in their reports at all – based on a calculation of the liability risk they face under Section 10(b) of the Securities Exchange Act.
The researchers are Lijun Lei of the University of North Carolina at Greensboro, Sydney Qing Shu of Miami University of Ohio, and Wayne Thomas of the University of Oklahoma. The researchers published a summary of the findings in Columbia Law School’s Blue Sky blog.
