A new study from researchers at the University of North Carolina, Miami University of Ohio, and the University of Oklahoma finds that a reduction in the overall expected securities litigation costs for companies plays a role in their voluntary environmental, social, and governance (“ESG”) reporting – albeit not in the way that might be expected. While demands for companies to voluntarily release ESG information is up, the reduction in risk on the cost front has not translated to companies issuing more ESG reporting. However, it has had an impact on the way in which companies talk about ESG in their reports, resulting in the overall adoption of a more optimistic tone in companies’ reports.
Setting the stage in their recently-published paper, “The Effect of Expected Shareholder Litigation on Corporate ESG Reporting: Evidence from a Quasi-Natural Experiment,” Lijun (Gillian) Lei, Sydney Qing Shu, and Wayne Thomas point to growing demand for ESG information from stakeholders and the general lack of strict regulation of ESG reporting. Against this background (and in light of rising litigation over ESG reporting), they state that senior lawyers view ESG-related disputes as the top source of litigation risk facing their organizations.
To gauge whether there is, in fact, a relationship between expected shareholder litigation and the issuance – and tone – of ESG reports, the authors use the Supreme Court’s 2010 decision Morrison v. National Australia BankLtd. The court’s decision in that case removed the possibility that investors that purchased a firm’s shares on non-U.S. exchanges could pursue damages for securities fraud in U.S. courts. This has served to reduce shareholder litigation costs for non-U.S. firms that trade on both U.S. and non-U.S. exchanges (hereafter, “U.S.-cross-listed foreign firms”).
Specifically, the authors looked at two key metrics in their report: If/how the tone used in companies’ ESG reports changed post-Morrison and whether the decision had an impact on whether companies issued voluntary ESG reports …
(1) Changes in the tone of ESG reports in response to the Morrison ruling – The authors found that U.S.-cross-listed foreign firms have increased their use of optimistic words relative to pessimistic words in their ESG reports in the post-Morrison period. This result is consistent with the notion that a decrease in expected litigation costs reduces firms’ concern about litigation tied to optimistic statements in their ESG reports.
“Plaintiffs filing lawsuits under Section 10(b) typically claim that defendant firms inflated their stock prices by providing misleading optimistic information or omitting negative material information. Consequently, optimistic tone in qualitative disclosures represents a primary target for shareholder class action complaints.”
The counterpoint here, according to the authors, is that trends in shareholder litigation might not actually impact the tone of ESG reports in light of “the long-standing debate over whether upbeat qualitative statements should be deemed material in investors’ decision-making or [whether they are] simply aspirational.”
(2) The impact of Morrison on the issuance of ESG reports – In terms of the voluntary issuance of ESG reports, the authors found that despite the post-Morrison potential reduction in shareholder litigation costs, U.S.-cross-listed foreign firms are less likely to release an ESG report. The reason, according to the authors, lies in insurance theory, which “predicts that a positive ESG reputation helps firms build moral capital that reduces punishment for their misconduct.” As such, “Firms report on their current ESG activities in an attempt to insure themselves against loss of firm value from negative future events that can trigger litigation.”
The bottom line here: The decrease in expected litigation costs following Morrison reduces the need for insurance, thereby lowering the incentive for firms to engage in costly ESG reporting.
> The authors found that Morrison has a stronger effect on ESG reporting among U.S.-cross-listed foreign firms headquartered in countries with weaker social norms toward ESG issues. In countries with stronger social norms, various stakeholders and incentives beyond expected shareholder litigation impose discipline on firms’ ESG reporting.
> Additionally, Morrison’s effect on the tone and issuance of ESG reports is stronger among U.S.-cross-listed foreign firms with legal experts in top management. Managers with legal expertise are likely more sensitive to the reduction in expected litigation costs associated with Morrison and its impact on the cost-benefit tradeoff decisions in ESG reporting.
> Finally, Morrison has a stronger impact on the tone and issuance of ESG reports for U.S.-cross-listed foreign firms with lower U.S. institutional ownership. We use U.S. institutional ownership as a proxy for the extent to which shares of U.S.-cross-listed foreign firms are traded on U.S. exchanges, which directly affects continued exposure to any securities litigation.
THE BIGGER PICTURE here, as the researchers note, is the overarching demand from investors and other stakeholders in recent years for information about firms’ ESG activities. While firms that supply this information stand to “receive greater economic and social rewards,” according to the authors, they also potentially set themselves up for litigation (in the form of securities class actions and/or false advertising suits), as indicated by a number of cases waged against companies based on the veracity of statements made in voluntary ESG reports.
Hicks v. Grimmway Enterprises, Inc. comes to mind here, with the agricultural corporation facing a false advertising casefor allegedly misrepresenting the environmental impact of its farming practices through its marketing. According to Plaintiff Elizabeth Hicks, Grimmway’s statements in its ESG report – namely, about its “regenerative farming” practices, its commitment to ESG (including its “responsible farming” practices and its adherence to “the industry’s most rigorous safety standards”), and its efforts to “preserv[e] natural resources” – are “false, deceptive, and misleading” because its farming method causes “severe harm to the ecosystem, and to its neighbors and communities.”