Corporate Misconduct and Prosocial Investing

Corporate misconduct, which can lead to legal risks such as regulatory fines and lawsuits, has long been a contentious issue in corporate governance, finance, and accounting. In our recent study, "Corporate Misconduct and the Capital Allocation of Prosocial Investors," we examine how institutional investors with prosocial mandates navigate these challenges. Our paper investigates whether these investors’ portfolio decisions are shaped by their clients’ ethical preferences and forward-looking insights into corporate misconduct. We focus on institutional investors explicitly catering to prosocial clients. These funds—characterized by their socially responsible or ESG-focused mandates—respond not only to public information but also utilize proprietary data to evaluate firms' future misconduct risks.

Prosocial Investors’ Capital Allocation and Corporate Misconduct

We introduce a novel firm-level metric called “prosocial overweight,” which measures the extent to which prosocial funds’ holdings differ from those of their conventional peers. This metric captures the collective judgment of prosocial investors, offering a lens to evaluate their preferences and expectations regarding corporate behavior.

Our study employs a revealed-preference methodology rather than relying on third-party ESG ratings, which often suffer from inconsistencies. By analyzing the actual portfolio decisions of prosocial funds, we provide a direct measure of perceived corporate values and compliance. This approach not only validates the commitment of prosocial investors to ethical investing but also highlights their ability to generate proprietary insights that extend beyond publicly available information.

Central to our analysis is the use of comprehensive datasets on regulatory violations and civil lawsuits. To measure corporate misconduct, we utilize data from Good Jobs First’s Violation Tracker, which includes penalties exceeding $5,000 assessed by U.S. federal and local agencies. This dataset encompasses a wide range of violations, from environmental breaches to financial misconduct. Additionally, we leverage a novel dataset from Lequity, an ESG rating firm, which tracks civil lawsuits filed in state and federal courts. Unlike other ESG data providers, Lequity identifies all defendants in a lawsuit and covers a broader range of legal disputes. Together, these sources provide an unprecedented view into corporate behavior, enabling us to capture both regulatory violations and controversies involving stakeholders. By analyzing these datasets, we establish a robust measure of firms' legal and ethical compliance. 

Empirical evidence reveals that prosocial funds avoid exposure to future regulatory fines and lawsuits through the firms they select. This suggests that prosocial investors possess proprietary insights into firms’ compliance and ethical practices. However, this advantage comes at the cost of lower risk-adjusted returns, particularly for riskier stocks.

Key Findings

1. Sensitivity to Legal Risk - Prosocial funds exhibit greater sensitivity to corporate legal risks compared to conventional funds. When exposed to companies with past regulatory violations or lawsuits, these funds experience significant outflows—a response driven by their clients’ strong aversion to misconduct. To mitigate these risks, prosocial funds actively reduce their holdings in firms with higher probabilities of future misconduct.
2. Predictive Power of Trades - The trading behavior of prosocial funds exhibits predictive power. By adjusting their portfolios, these funds respond not only to past legal infractions but also anticipate future violations and lawsuits. Specifically, an increase in prosocial overweight predicts a reduction in the likelihood of regulatory fines or lawsuits in the following year. This highlights the ability of prosocial funds to incorporate forward-looking information into their investment decisions.
3. Financial Trade-offs - While prosocial funds effectively align their portfolios with clients’ ethical values, this alignment entails financial costs. Firms with greater increases in prosocial overweight often deliver lower risk-adjusted returns. This trade-off is especially pronounced for stocks characterized by high idiosyncratic volatility and ESG-rating dispersion, where the same reduction in expected legal risk is associated with a steep decline in financial performance.

Implications for Corporate Governance

The research offers important insights for both investors and corporate managers. For investors, it emphasizes the value of prosocial mandates in directing capital toward firms with stronger compliance records and ethical practices. However, it also underscores the inherent trade-offs, calling for careful consideration of social objectives alongside financial performance.

For corporate managers, the study provides a compelling case for prioritizing legal and ethical compliance. Firms that proactively align with societal norms are more likely to attract capital from the growing pool of prosocial investors, potentially lowering their cost of capital over time. Conversely, a poor compliance record can result in divestments and reputational damage.

These findings contribute to broader debates in corporate governance, particularly regarding the role of institutional investors in promoting accountability and ethical behavior. While prior research has often focused on the financial aspects of ESG investing, this study shifts attention to its social dimensions. It also raises critical questions about the limits of prosocial investing: Can it effectively deter corporate misconduct? And at what cost to financial performance?

As prosocial investing continues to expand, its impact on capital allocation and corporate behavior is becoming increasingly significant. This study explores how prosocial preferences shape investment strategies, highlighting both the investment activity and the trade-offs involved in aligning portfolios with societal values. For investors, policymakers, and academics, the research provides valuable insights into the evolving landscape of ethical investing and its implications for corporate governance.

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By Stefano Pegoraro (University of Notre Dame - Department of Finance), Antonino Emanuele Rizzo (Nova School of Business and Economics), Rafael Zambrana (University of Notre Dame - Mendoza College of Business)

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