Much evidence shows that a firm’s environmental, social, and corporate governance engagement — also known as its corporate social performance (CSP) — is relevant to investment performance and firm risk. CSP measures can be perceived as a risk management initiative, and high positive CSP can help a firm build up a “reservoir of good will,” one that could mitigate negative impacts on performance during a corporate crisis.

This study examines whether environmental, social, and governance (ESG) factors affect a firm’s performance in the context of one type of extreme event: class action lawsuits. It looks at the extent to which past ESG controversies predict future class action lawsuits and whether ESG performance affects the impact of such lawsuits on firm value.

The authors start by testing the relationship between CSP and the probability of litigation. They estimate positive CSP with a measure of ESG performance that looks at how a firm performs across such issues as emissions, human rights, and shareholder rights. Negative CSP is estimated with a measure of ESG controversies that mainly reports the number of ESG controversies a firm was involved with in the past year, benchmarked against industry peers. They use three proxies to measure litigation risk from different angles.

They adopt an existing model of litigation risk and adapt it to incorporate their ESG performance and ESG controversies scores. To measure positive and negative CSP, they use data from Thomson Reuters that rate US firms on 178 ESG issues from 2003 to 2017. They obtain class action lawsuit data related to US securities stemming directly from US court records. They apply multiple panel regressions to their final sample of 7,671 firm-year observations to estimate the probabilities of class action lawsuits, and they estimate one probit model for each of the three proxies of litigation risk.

Next, the authors test whether firms with positive CSP build up “moral capital” that provides insurance-like effects during class-action lawsuits, thus reducing the negative impact of litigation on firm value. They apply a market-based event study to measure firms’ abnormal returns in the window before and after the filing date of the lawsuits. They also compare actual returns of firms involved in litigation with matched firms facing no litigation during the sample period.

Finally, the authors test whether implementing their findings in a trading strategy yields positive alpha. They predict the probabilities of class action lawsuits for each sample firm-year from 2014 to 2017, and they create four long-only factor portfolios that group firms by litigation probability and ESG performance. They then calculate equally weighted and value-weighted monthly portfolio returns, for which they estimate monthly alphas.

The authors find that having fewer ESG controversies is linked to lower litigation risk. For an average firm, a one standard deviation improvement in ESG controversies reduces the annual probability of a class action lawsuit being filed from 3.1% to 2.4% — a drop of more than one-fifth.

Better ESG performance is also shown to provide some protection against the negative impacts of litigation on firm value. For example, an average sample firm with a low positive ESG performance score experiences an excess loss in market value of about US$1.14 billion compared with a firm with a high positive ESG performance score — equivalent to more than 5% of the average market capitalization. The matching approach supports the conclusion that top performing ESG firms experience markedly less negative abnormal mean returns before class action lawsuit filings and better recovery after.

An investment strategy that buys stocks with low predicted litigation risk provides significantly higher alphas than portfolios of stocks with high exposure to litigation. The portfolios that combine firms with low litigation risk and high ESG performance yield monthly alphas between 0.71% and 0.73%. Even after accounting for transaction costs, these alphas remain positive. In the case where an investment manager is compelled to select stocks with higher litigation risk, due to investment style or restrictions, the results suggest that high CSP scores moderate negative performance.

This study’s findings suggest that investors should consider CSP metrics as relevant to both the probability that a firm faces class action lawsuits and the potential impact of litigation on firm value. Litigation risk exposure can be incorporated into the investment process by considering the number of ESG controversies a firm is involved in relative to industry baselines.

Moreover, the insurance-like effect of high CSP might help firms retain value during a corporate crisis and shield them from financial distress, to some extent. The authors show that an investment strategy based on low litigation risk and high ESG performance yields positive alphas, even after transaction costs.