In an earlier post, I discussed my paper arguing that significant changes to the corporate-disclosure regime should trigger review of aspects of the securities-fraud regime. This is because the disclosure regime and the securities-fraud regime go hand-in-hand. So if something like the emergence of ESG occurs on the disclosure side of things, then the extent to which changes on the anti-fraud side would be desirable and should be considered. In a new essay, I build on that paper to focus on interactions between ESG disclosure and the anti-fraud regime that run in the opposite direction (i.e., interactions where ESG-specific changes to the litigation and enforcement regime can affect the quantity of ESG disclosure).

The main argument in the essay is that there is a fundamental trade-off involving the level of anti-fraud litigation and enforcement in the ESG area, on the one hand, and the amount of non-financial ESG disclosure firms will produce, on the other. In particular, I argue that if society gives up marginal benefits of the litigation and enforcement regime relating to non-financial ESG disclosure, it can gain the benefits of more such disclosure from firms.

The existence of this trade-off, and thus the potential for reforms that would likely lead to more non-financial ESG disclosure, is traceable to an underlying market failure. Supplying disclosure is costly to firms, yet firms do not internalize anything close to the full scope of the benefits of the disclosure they supply. So when left to decide how much they will disclose, firms will share too little from the perspective of society. When the law makes disclosure even more costly for firms by subjecting it to something like the current securities-specific litigation and enforcement regime, the under-disclosure problem is exacerbated. And while the mandatory-disclosure regime can help generate more disclosure, it also introduces disclosure-overproduction concerns associated with special-interest politics and rent-seeking regulators.

To be sure, the fact that the litigation and enforcement regime chills corporate disclosure on the margin is both well-established (as a matter of theory and evidence) and fairly obvious. But there is much reason to believe that the trade-off is especially important in the context of non-financial ESG disclosure for four main reasons.

First, in that context, there is special concern for the disclosure-underproduction problem. Relative to the situation with respect to traditional, cash-flow-focused corporate disclosure, the benefits of at least environmental and social disclosure are generally internalized by the firm less, yet the cost of producing that disclosure for firms is likely about the same or even higher than it is for more traditional corporate disclosure. (The latter appears to be the case for at least disclosure items like those relating to the climate impact of a firm’s suppliers.)

Second, in contrast to the scope of traditional disclosure that firms must currently make, the scope of required non-financial ESG disclosure is now relatively small. And while a number of prominent laws requiring climate disclosure have come into effect this past year or two, the ultimate scope of required non-financial ESG disclosure is still very unclear and controversial. For this reason, there is much room for disclosure of at least non-financial ESG information on firms’ own accord at a cost to the firm that is lower than the value placed on the disclosure by information consumers and society generally.

Third, the same reasoning suggests that there is much room for welfare-enhancing disclosure requirements to be implemented thanks to less firm resistance to them should the relevant litigation and enforcement costs be reduced. In other words, it is not just that firms will produce more of this non-financial ESG information voluntarily. Instead, it’s that they will influence and challenge ESG disclosure requirements less, thereby leading to more mandatory disclosure requirements on the margin.

Fourth, and related to the third point, the result of pursuing gains in non-financial ESG disclosure in this way would be not just more non-financial ESG disclosure by firms, but also less corrupted disclosure of that variety. In short, while principled arguments from those in the issuer-disclosure and securities-fraud world can be helpful, these types of reforms would give the plaintiff-side bar less reason to lobby Congress and attempt to sway the SEC on the scope of the disclosure requirements based on their special interests. The same applies on the defense side of things for at least firms and the associations that represent their interests.

These points should lead to a cost-benefit analysis that begins by recognizing that the result of pursuing social gains associated with increased non-financial ESG disclosure by cutting back on the litigation and enforcement regime would likely be less credible non-financial ESG disclosure. This dictates that relevant reforms should only be pursued when we would expect the marginal benefits of the increased non-financial ESG disclosure at issue (and any other benefits of such reforms) to dominate the loss of those credibility enhancements (and any other costs of the reforms). But on the disclosure-gains side of the ledger, there appears to be much demand for additional non-financial ESG disclosure. And on the loss-of-litigation-and-enforcement-benefits side, there are a number of aspects of the litigation and enforcement regime that likely provide very little in terms of disclosure-credibility enhancements on the margin, yet that impose serious costs on defendants—and that thus should be viewed as, at best, questionable.

In the end, ESG-specific reforms to the litigation and enforcement regime should be considered within this cost-benefit framework in light of the promise of additional non-financial ESG disclosure and the questionable nature of many aspects of the current litigation and enforcement regime.

This post comes to use from Professor Kevin S. Haeberle at the UC Irvine School of Law. It is based on his recently published essay, “Reforming Securities Litigation & Enforcement for ESG Disclosure” available here.