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.
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
—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.
Where investors harbor long-term value expectations that the market does not share, courts are systematically unable to protect their interests in truthful disclosure.
Rule 10b-5 makes corporations liable for material misrepresentations, with materiality defined broadly based on significance to investors.
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.
Nonetheless, the growing interest in what is sometimes called Environmental, Social, and Governance (ESG) demonstrates the need for accountable disclosure.
While misrepresentations about sustainability cause legally cognizable harm to investors,
securities-fraud doctrine cannot provide a solution to the extent those misrepresentations fail to impact stock price.
A contract solution is therefore needed to police misrepresentations in sustainability disclosures.
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.
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.
While this “hidden value model” previously has been applied to corporate boards,
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.
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.
While Delaware courts protect a board’s perceptions of hidden value, they are more reluctant to put a price tag on them.
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.
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.
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.
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.