The SEC has proposed mandating climate disclosure to meet investor demand for information about the environmental risks firms face and managers’ plans to mitigate their firms’ environmental impacts. Yet critics worry that the proposed mandate would increase risks of litigation for issuers, and there have, in fact, been more corporate lawsuits involving environmental disclosures. In a recent study, we investigate whether litigation risk is associated with firms’ environmental disclosure decisions in the currently voluntary disclosure regime.
Shareholders can bring class action lawsuits against publicly traded firms for misrepresenting or omitting information that is material to investors. As a result, prior research suggests that managers face conflicting incentives when incorporating litigation risk into their voluntary financial disclosure decisions. On one hand, when managers are primarily concerned with being sued for failing to provide information (i.e., “omission risk”), litigation risk can motivate managers to provide more disclosure. On the other hand, if managers fear being sued for providing disclosure that is revealed to be inaccurate ex post (i.e., “misrepresentation risk”), then litigation risk can motivate managers to provide less disclosure.[1]
If sustainability information is material to investing decisions, managers may also be concerned that their environmental disclosures will invite shareholder litigation. For example, managers may worry about being sued for omitting information about material climate risks or misrepresenting the impact of their operations on the environment. As a result, it is unclear whether managers will increase or decrease total environmental disclosure. Moreover, we expect the increasing investor demand for these disclosures to constrain managers’ ability to materially change the amount of disclosure provided. Therefore, in our study, we examine whether managers respond to litigation risk by adjusting the nature of the environmental information they disclose.
While managers can voluntarily provide both historical and forward-looking environmental information, we expect these disclosures to be associated with different types of litigation risk. Importantly, although both historical and forward-looking environmental disclosures likely invite omission risk, we expect these disclosures to diverge in misrepresentation risk. For example, environmental information (such as direct and indirect GHG emissions) is increasingly verifiable and may be plausibly demonstrated to have been misrepresented. In contrast, forward-looking environmental disclosures are generally associated with very long time horizons (e.g., firms often issue 2040 or 2050 emissions targets in 2023). To the extent forward-looking environmental disclosures are less verifiable, the misrepresentation risk associated with these disclosures should be relatively low. For these reasons, we expect firms perceiving litigation risk associated with their environmental disclosures to minimize misrepresentation risk by including relatively more forward-looking (and less historical) environmental disclosure.
We argue that when a peer company is sued for its environmental disclosures, managers will perceive an increase in the litigation risk most relevant to their environmental disclosure decisions. We initially identify 97 corporate lawsuits related to environmental issues from the U.S. Climate Change Litigation database, 26 of which are related specifically to corporate disclosure. Our empirical design further restricts the lawsuits we are able to use in our study, and as a result, we incorporate seven lawsuits in our primary analysis. We expect managers of firms in the same industry as the sued firm to perceive the greatest increase in litigation risk in conjunction with the environmental disclosure lawsuit and compare their disclosures to those of firms in industries similar to (but not the same as) the sued firm.
Our analysis primarily focuses on companies’ environmental disclosures in their conference calls. We examine conference calls because they are important events for the firm, managers exercise full discretion over their contents, and they are often cited in corporate lawsuits. We rely on text from the GRI reporting standards to identify conference call sentences that include environmental language. We then identify forward-looking environmental disclosures as the subset of these sentences that also contain a forward-looking phrase. We capture the firm’s decision to provide more forward-looking (and less historical) environmental disclosure in its conference calls with the percentage of environmental disclosure words occurring in the subset of forward-looking sentences.
Consistent with our expectations, we provide robust evidence that firms provide relatively more forward-looking environmental disclosure in their conference calls after a peer firm is sued for its environmental disclosures. We also show that the response is stronger for firms facing higher litigation risk before their peer’s lawsuit and that firms lengthen the horizon of their environmental disclosures after a peer is sued. This result further supports our assertion that managers attempt to minimize the misrepresentation component of litigation risk by providing less verifiable disclosures. Moreover, we provide some evidence that the disclosure response is stronger when the lawsuit explicitly references conference call disclosures or receives substantial media coverage, further supporting our assertion that managers are aware of peers’ environmental disclosure lawsuits and it is indeed litigation risk that likely motivates the disclosure adjustments.
In additional tests, we confirm our main result persists when we identify litigation risk with an alternative firm-year litigation risk measure in a broader sample, helping to rule out the possibility that our results are an artifact of affected-industry characteristics or the time-periods surrounding the lawsuits. We also examine quantitative emissions disclosures gathered from all available disclosure sources and document that firms are more likely to provide future emissions targets and less likely to disclose historical emissions after a peer firm is sued for its environmental disclosures. This result helps mitigate concerns that the disclosure adjustments are limited to conference calls.
Collectively, our findings offer early evidence that firms’ voluntary environmental disclosure decisions are sensitive to litigation risk. We hope these findings will inform the SEC’s efforts to draft climate disclosure mandates by documenting companies’ nuanced disclosure responses to environmental disclosure litigation risk in the current regulatory regime. Specifically, our findings provide insight into which environmental disclosures firms may be less likely to voluntarily provide in the absence of disclosure mandates. Overall, our results are consistent with firms perceiving relatively high litigation risk associated with some disclosures the SEC is considering mandating (e.g., historical emissions) and relatively low litigation risk associated with others (e.g., environmental risks and emissions targets).
ENDNOTES
[1] See for example Naughton et al. 2019; Skinner 1994, 1997; Baginski et al. 2002; Johnson et al. 2001; Rogers and Van Buskirk 2009.
This post comes to us from Scott Robinson, a PhD candidate at the University of Colorado, Professor Nikki Skinner at the University of Georgia, and Professor Jasmine Wang at the University of Virginia. It is based on their recent paper, “Litigation Risk and Environmental Disclosure Decisions,” available here.