Recidivism is a fundamental idea in law enforcement. Past bad behavior, sometimes even in unrelated fields, tends to predict an individual’s proclivity to cross the line in the future. Might the same insight hold for irresponsible ESG behavior of a firm? Will a company’s record of violations related to worker welfare, product safety or environmental damage predict reporting shenanigans?
To evaluate this conjecture in the corporate context, my co-authors (Shuqing Lo and Simi Kedia) and I combined ESG data from several sources for 4,621 unique firms spanning the years 1994 to 2011. Product safety data comes from the Food and Drug Administration (FDA). Information on worker safety and worker civil rights is drawn from four different federal government agencies, which include the Mine Safety and Health Administration (MSHA), the Occupational Safety and Health Administration (OSHA), the Office of Federal Contract Compliance Programs (OFCCP), and the Wage and Hour Division (WHD) of the Department of Labor (DOL). Environmental violations are collected from the Environmental Protection Agency (EPA).
As hypothesized, we found that a firm’s prior noncompliance record on ESG activities is statistically associated with the likelihood of subsequent financial misreporting measured as (i) a material earnings restatement; (ii) the issue of a subsequent Accounting and Auditing Enforcement Release (AAER) by the SEC; or (iii) the violation of disclosure laws or GAAP (Generally Accepted Accounting Principles) alleged via a securities class action lawsuit. Although all these misreporting outcomes are serious, an AAER is issued by the SEC only for the most egregious cases of accounting misconduct.
Before you conclude these are small unknown companies, let me tell you that the persistent ESG violators tend to be older, larger and more profitable. Pfizer, Waste Management and Caterpillar feature among our top violators. Caterpillar has been charged with recurrent violations of the Clear Air Act. Pfizer has been labeled a “repeat offender” by the DOJ, has pleaded guilty to illegal marketing of drugs, and has faced allegations of bribery of foreign officials. Waste Management has been accused of violating antitrust laws, labor contracts, and environmental regulation. Interestingly, all these firms have either restated their books or have been hit with a lawsuit for violating GAAP or an AAER in future periods.
The statistical patterns we observe are economically important as well. A one standard deviation increase in ESG noncompliance relative to its mean is associated with a 12.5% increase in the likelihood of a restatement, a 25% increase in the likelihood of an AAER, and an 11% increase in the likelihood of a private class action lawsuit.
So, why do we observe this statistical association? We suspect that the cultural forces driving ESG violations influence financial misreporting as well. A cultural climate in which corporate leadership looks the other way when violating an environmental rule is perhaps a few steps away from tacitly endorsing cooking the books. These are usually environments where the unstated message from leadership is that hitting the financial target or getting the job done is much more important than the means of getting there. New employees to the firm initially get co-opted into this line of thinking. A slippery slope of small but repeated increases in unethical behavior eventually leads to a hardened attitude whereby employees rationalize such behavior by telling themselves, “everyone else in our industry is doing the same thing.”
The remarkable finding is that the firm’s culture, as opposed to the impact of a few errant CEOs, explains the data better. Even when we look at firms where CEOs have been replaced, the firm’s ESG noncompliance record predicts future financial reporting risk. Hence, “bad barrels,” or a persistent culture at the firm, as opposed to “bad apples,” or ethically challenged CEOs, are more likely to drive our findings.
So, keep an eye on how companies treat their stakeholders (workers, the environment, their communities and of course their customers). A firm’s ESG record can serve as an early warning about serious offenses such as fraud down the line.
Shiva Rajgopal is the Kester and Byrnes Professor of Accounting and Auditing at the Columbia Business School. He is widely published in finance and accounting journals. His research is frequently cited in the popular press, including The Wall Street Journal, The New York Times, Bloomberg, Fortune, Forbes, Financial Times, Businessweek, and The Economist.