HIDDEN VALUE INJURY - Columbia Law Review

Rule 10b-5 and the securities-fraud action provide a private enforcement tool only where litigants can show a defendant’s misrepresentation impacted the price of a security. But investors increasingly demand disclosure about how a corporation interacts with stakeholder groups such as employees, consumers, and communities. Because these “sustainability disclosures” are aimed at long-term value, misrepresentations will only incidentally impact immediate stock returns, so investors are left without legal recourse. Borrowing from Delaware antitakeover law, this Note argues that investors suffer a “hidden value” injury when corporations materially misrepresent sustainability information. Delaware recognizes and protects idiosyncratic value expectations by allowing corporate boards to stand between a willing buyer and tendering shareholders merely because the board believes the price is too low. Extending this model to shareholders shows how investors can hold legitimate value expectations not reflected in the stock price. Investors who believe based on sustainability disclosures that the market undervalues a company’s stock are harmed when those disclosures turn out to be false. The hidden value model also shows, however, that this harm is inherently difficult for courts to value. Therefore, this Note argues for a private-ordering solution to allocate the cost of sustainability misrepresentations. In particular, it proposes that corporations issue conditional stock options that vest only when a corporation can be shown to have materially misrepresented their sustainability performance. This mechanism can guarantee the truthfulness of sustainability disclosure without creating undue liability for corporations. By pointing to a private-ordering solution, this Note hopes to elucidate the crucial but unquantifiable nature of the hidden value injury that results from sustainability misrepresentations.

The full text of this Note can be found by clicking the PDF link to the left.

* J.D. Candidate 2021, Columbia Law School. With thanks to my advisor, Professor Zohar Goshen, for his mentorship, and to the entire staff of the Columbia Law Review. To my siblings, for being my first and best teachers. To Erin, for more than I know how to express. And finally, to my parents, who, I hope, can say that they only had children like themselves.

Introduction

Over the last twenty-five years, U.S. securities-fraud class actions have generated more than $100 billion in settlements—that is, $100 billion in incentives for corporations to tell the truth. 1 Key Statistics, Stan. L. Sch. Sec. Class Action Clearinghouse, http://securities.stanford.edu/stats.html [https://perma.cc/8NTG-KCSU] (last visited Oct. 24, 2020). But those incentives are trained almost exclusively on finances, cash flows, and earnings estimates, rather than how a corporation interacts with the environment, employees, customers, and suppliers 2 Virginia Harper Ho, “Enlightened Shareholder Value”: Corporate Governance Beyond the Shareholder–Stakeholder Divide, 36 J. Corp. L. 59, 91 (2010) (noting that mandatory sustainability disclosures are spotty and voluntary disclosures are selective and, on the whole, inadequate); see also infra Part II (noting how plaintiffs have struggled to hang liability on sustainability disclosures). —what this Note broadly calls “sustainability information.” Because this information goes to the long-term value of a corporation but not necessarily its short-term value, investors may find it material even where it fails to move markets. But the securities-fraud action measures damages by stock-price impact, meaning investors lack the ability to vindicate their long-term value expectations based on sustainability information. 3 See infra section II.B. Where investors harbor long-term value expectations that the market does not share, courts are systematically unable to protect their interests in truthful disclosure. 4 See Caitlin M. Ajax & Diane Strauss, Corporate Sustainability Disclosures in American Case Law: Purposeful or Mere “Puffery”?, 45 Ecology L.Q. 703, 718–23 (2018) (analyzing the thin case law on the subject of Rule 10b-5 litigation over sustainability and concluding that the path to liability is likely narrow). But see Rick E. Hansen, Climate Change Disclosure by SEC Registrants: Revisiting the SEC’s 2010 Interpretive Release, 6 Brook. J. Corp. Fin. & Com. L. 487, 541–42 (2012) (noting that while fraud liability for failure to disclose climate change effects is unlikely, the threat of securities litigation over sustainability information may deter misleading statements).

Rule 10b-5 makes corporations liable for material misrepresentations, with materiality defined broadly based on significance to investors. 5 Basic Inc. v. Levinson, 485 U.S. 224, 232 (1988) (adopting the materiality standard from TSC Industries for Rule 10b-5 suits); TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976) (“An omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important . . . .”); 17 C.F.R. § 240.10b-5 (2020). But the securities-fraud doctrine that has grown up around it bars class action lawyers and activist investors from applying the Rule to sustainability disclosures. 6 See infra section II.B. Nonetheless, the growing interest in what is sometimes called Environmental, Social, and Governance (ESG) demonstrates the need for accountable disclosure. 7 See infra section I.A.2. While misrepresentations about sustainability cause legally cognizable harm to investors, 8 See infra section I.B. securities-fraud doctrine cannot provide a solution to the extent those misrepresentations fail to impact stock price. 9 See infra section II.B. A contract solution is therefore needed to police misrepresentations in sustainability disclosures. 10 See infra Part III.

This Note borrows the concept of “hidden value” from Delaware takeover jurisprudence to better define stockholders’ interest in truthful sustainability disclosure. Delaware law allows boards to block hostile takeovers merely by saying the price is too low, implying that boards are able to see value that the stock market misses. 11 See Paul L. Regan, What’s Left of Unocal, 26 Del. J. Corp. L. 947, 973 (2001) (arguing that Delaware case law allows boards to “protect shareholders from mistakenly failing to understand the value of management’s existing business plan” and accepting a tender offer at a too-low price). Professors Bernard Black and Reinier Kraakman describe this quantity as “hidden value”: hidden in the sense that boards can perceive it while the market cannot. 12 See generally Bernard Black & Reinier Kraakman, Delaware’s Takeover Law: The Uncertain Search for Hidden Value, 96 Nw. U. L. Rev. 521 (2002) (laying out the “hidden value model”). While this “hidden value model” previously has been applied to corporate boards, 13 Id. it can also describe investors. Just as board directors can perceive and protect above-market value, investors can form legitimate value expectations that exceed the value reflected in the market price. Investors who study and believe a board’s sustainability disclosures may conclude, based on those disclosures, that the stock is underpriced. 14 This insight is bolstered by the rise of socially responsible investing. These investors rely on corporate disclosures to restrict their investments to companies they identify as socially responsible. See The Rise of Responsible Investment, KPMG, https://home.kpmg/xx/en/home/insights/2019/03/the-rise-of-responsible-investment-fs.html [https://perma.cc/B6J9-5TPW] (last visited Oct. 24, 2020) (“The rise in ESG considerations on the part of businesses and investors is happening in tandem with a heightened regulatory environment that has also increased ESG requirements and accounting standards demanding transparency around disclosures in financial statements.”). And when those disclosures turn out to be false, the investor suffers a cognizable injury. That injury—which this Note terms hidden value injury—represents an interest that Delaware courts protect but securities-fraud doctrine ignores.

This analogy also demonstrates why securities fraud fundamentally cannot account for long-term value expectations outside stock price. Hidden value is hidden for a reason: It is not easily communicated either to markets or the courts. 15 See Black & Kraakman, supra note 12, at 522–23. While Delaware courts protect a board’s perceptions of hidden value, they are more reluctant to put a price tag on them. 16 See, e.g., Del. Code tit. 8, § 262(g) (2020) (limiting the right of shareholders to ask the courts to appraise the value of their shares in merger proceedings). Generalist judges in the federal courts should be even more hesitant to guess at this obscure quantity.

Because courts would be hard pressed to determine hidden value after the fact, investors should protect their reliance interest on sustainability disclosure by defining them ex ante by contract. 17 See Charles J. Goetz & Robert E. Scott, Liquidated Damages, Penalties and the Just Compensation Principle: Some Notes on an Enforcement Model and a Theory of Efficient Breach, 77 Colum. L. Rev. 554, 568–72 (1977) (analyzing how contracting parties in the analogous context of liquidated damages can use ex ante contracting to try to protect idiosyncratic value). This Note suggests that conditional warrants can guarantee the truthfulness of sustainability disclosure where securities doctrine fails. Warrants are board-issue contracts that allow their holders to purchase stock from the board at a particular time and price. 18 6A Fletcher Cyclopedia of the Law of Corporations § 2641, Westlaw (database updated Sept. 2020) (“Warrants constitute an agreement between the corporation and the warrant holder that the corporation will sell to the warrant holder a specified number of shares at a set price.”). Boards and investors can use these options to record the value expectations of both parties. Using conditional warrants to price sustainability information, corporations and investors can more efficiently allocate the cost of untruthful disclosure.

This Note proceeds in three Parts. Part I describes the state of sustainability disclosure and uses an analogy to hidden value to demonstrate why investors may find it material even where it fails to impact stock price. Corporations disclose information about nonfinancial performance even when under no obligation to do so. But the fact that investors cannot rely on the truthfulness of disclosures produces an information asymmetry reflected in the diffuse and unaccountable nature of sustainability reporting. The analogy to Delaware takeover law shows that while sustainability information can give rise to legitimate and legally cognizable interests, the failure of an enforcement regime leaves disclosure irregular, unreliable, and diffuse.

Part II shows how even a securities-fraud action that pleads a material sustainability claim runs up against a de facto price-impact requirement. The hidden value model justifies this requirement, even though requiring price impact screens out a legitimate investor interest in truthful sustainability disclosure. Hidden value necessarily eludes the markets’ attempts to incorporate it into the stock price. While these elusive long-term value expectations go against the orthodoxy of efficient capital markets, they help describe why sustainability disclosure escapes enforcement in the courts.

To that end, Part III suggests three alternative solutions. First, investors can research a company’s sustainability claims by themselves before making investment decisions. This alternative—the status quo—imposes high search costs on investors, despite the fact that corporations have easier access to relevant information. Second, corporations could guarantee investors’ long-term returns by issuing put options at the price investors expect the security to reach. 19 A put option is a right to sell stock at a set future date and price. 5B Arnold S. Jacobs, Disclosure and Remedies Under the Securities Law § 9:84, Westlaw (database updated Sept. 2020) [hereinafter Jacobs, Disclosure and Remedies]. These guarantees, however, would impose undue liability by asking corporations to insure their stock price movements. Finally, corporations can guarantee long-term returns conditioned on the truthfulness of their sustainability disclosure. Thus, an issuer would be liable only if it knowingly misrepresented its sustainability performance. This Note argues that these conditional warrants would enforce investor interests in sustainability better than securities-fraud doctrine is able to.