ESG Securities Fraud

James J. Park is a Professor of Law at UCLA. This post is based on his recent article, forthcoming in the Wake Forest Law Review. Related research from the Program on Corporate Governance includes Rethinking Basic (discussed on the Forum here) by Lucian Bebchuk and Allen Ferrell; and Price Impact, Materiality, and Halliburton II (discussed on the Forum here) by Allen Ferrell and Andrew H. Roper. 

The 2019 collapse of the Brumadinho dam in Brazil not only released 12 million tons of mining waste and took 270 lives, it prompted the filing of a major securities fraud enforcement case in the United States by the Securities & Exchange Commission (SEC). Vale, the public corporation that owned the dam, had New York Stock Exchange-traded securities, which lost 25 percent of their value in the wake of the crisis. The government lawsuit argued that Vale misled investors about the risk of its 2019 dam collapse, not only in the quarterly reports it must file with the SEC as a public company, but also in sustainability reports that it had voluntarily provided to investors.

The Vale case, which resulted in the payment of $55 million to settle the SEC’s action, is one of a number of high-profile securities fraud cases filed over the last decade by the SEC and investors alleging that a public company misled investors about the risk of a scandal or disaster. Such enforcement has coincided with the growing importance of Environmental, Social, and Governance (ESG) matters to the modern public corporation. Investors are more concerned about the economic risks of corporate misconduct, which can result in reputational harm and governmental sanction.

Partly to reassure investors, public corporations are increasingly issuing ESG disclosures. Many of these disclosures are voluntary and provide representations about a company’s efforts to manage ESG risk. The SEC has also recently proposed significant mandatory disclosure requirements relating to ESG issues such as climate change and cybersecurity. As corporations increasingly make representations about their management of ESG risk, there will be more opportunities to contend that they misrepresented such risks. Some commentators have described ESG securities fraud cases as event litigation, where any corporate event that causes a significant stock price decline could potentially violate Rule 10b-5.

The criticisms of ESG securities fraud cases in many ways mirror longstanding concerns about Rule 10b-5 litigation arising out of business failures. Whenever a business suffers a significant setback that prompts its stock price to fall, there is an opportunity for investors to argue that corporate managers misrepresented the risk of such a setback. Such litigation often turns on the extent to which the corporate defendant and its agents had knowledge about such risk and issued misleading statements denying the existence of the risk. Like cases involving the misrepresentation of a business risk, cases alleging misrepresentations about ESG risk are complicated partly because they involve assessing knowledge about the risk of failure rather than a setback that is known. On the other hand, ESG securities fraud cases differ from business failure risk cases because they relate to deceptions concerning a wider range of risks that can be more difficult for corporate managers to predict.

Because of the concerns relating to adjudicating ESG risk, courts have aggressively dismissed ESG securities cases, particularly those brought by private plaintiffs. They have done so primarily by applying the puffery doctrine, a longstanding presumption that rosy statements of optimism should not be taken literally. For example, if a company claims that it is “committed to product safety,” even if it knows there is a high risk that its products are defective, a court may find under the puffery doctrine that there was no material misrepresentation to investors.

This Article argues that the current approach taken by courts in deciding ESG securities fraud cases, which emphasizes the puffery doctrine, misses the core issue raised by these cases, and should be replaced by a more holistic approach that emphasizes assessment of the materiality of the ESG risk at issue. Rather than arbitrarily screening cases by assessing the specificity of statements relating to ESG risk, courts should closely examine whether a material ESG risk exists. If it did, it is more likely that the statements obscuring that risk are misleading, managers acted with fraudulent intent, and investors can argue that they paid too much for the company’s stock.

In assessing the materiality of an ESG risk, courts should apply the well-established test set forth by the U.S. Supreme Court in Basic v. Levinson. This probability/magnitude test, which has not been cited by courts widely outside of the merger context, instructs courts to assess the materiality of a contingent event by weighing both the probability of the event occurring and the magnitude of the event. Like the possibility of a transformative merger, the possibility of an ESG event is a contingent event that is only material if its probability and magnitude are sufficiently high.

A necessary condition for the Basic test to apply is that it is possible to generate meaningful probabilities about the contingent event, what economists refer to as Knightian risk. For example, in the Vale case, there was evidence that Vale had calculated the probability that the dam would collapse and thus knew that its calculations showed that the dam was riskier than international standards. Because the probability of dam collapse was knowable and known, it was possible for the SEC to argue that the ESG risk was material and that Vale’s obfuscation of that risk was fraudulent.

In contrast, when meaningful probabilities with respect to an ESG risk cannot be generated by a company, when there is Knightian uncertainty, securities fraud liability relating to that risk should not be triggered. When a risk is essentially unknowable, there would be no meaningful asymmetry between the corporation and its investors with respect to a risk when it reflects a risk that cannot be calculated. The probability/magnitude test can thus be used as a way of limiting the costs of such litigation by assisting courts in separating good cases from bad.

Rather than applying the puffery doctrine in isolation, courts should weigh the specificity of ESG risk statements and the materiality of the ESG risk together using a sliding scale approach. For example, when there is a very specific representation about ESG risk, the burden of establishing the materiality of the risk under the probability/magnitude test would be more modest than when there is only a generic representation of ESG risk. On the other hand, plaintiffs would have a much higher burden to show that general statements of ethics or compliance can be misleading. They would need to prove more convincingly that there was a known or highly probable ESG risk of substantial magnitude.

The impact of shifting to a more holistic assessment of ESG securities fraud cases is likely to be positive. While there is a danger that some companies will avoid calculating ESG risks to avoid liability, such a course of action is unrealistic for public companies that are being pressured to generate ESG risk disclosure by investors and regulation. Rather than making arbitrary decisions based on the specificity of disclosures, adjudication of ESG securities fraud cases would assess the core issue in securities fraud cases, whether managers are deceiving investors about their knowledge of material information about a company’s value.

The full paper is available for download here.

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