ESG controversies, corporate governance, and the market for corporate control

ABSTRACT

Capitalizing on a unique measure of takeover vulnerability, we examine how the takeover market, which is widely regarded as a crucial instrument of external governance, influences environmental, social, and governance (ESG) controversies. This paper is the first to investigate how corporate control markets are influenced by the market for corporate control. The sample consists of unbalanced panel data from 6,236 firm-year observations during 2002–2014. We use Propensity Score Matching (PSM) and Instrumental Variable (IV) analyses to address potential endogeneity, and entropy-balancing approach to address the issue of observable selection. The results show that the disciplinary mechanism associated with the takeover market compels managers to take actions that benefit shareholders, thus avoiding ESG controversies. An increase in takeover susceptibility by one standard deviation resulted in a 10.12% decline in controversial activities. Furthermore, we find that firm profitability drops, and risk increases substantially in response to ESG controversies.

KEYWORDS:

• ESG
• corporate social responsibility
• ESG controversies
• takeovers
• corporate governance
• market for corporate control

JEL CLASSIFICATION:

• M14
• G32
• G34

I. Introduction

Although the literature is replete with research on corporate social responsibility (CSR) and environmental, social, and corporate governance(ESG) performance, ESG controversy has received little attention. ESG controversies should be investigated more frequently because they have been shown to substantially reduce firm value (Frooman 1997; Klassen and McLaughlin 1996). Investors paid high prices for ESG-related scandals. A study by Bank of America Merrill Lynchsuggests that major ESG-related controversies shaved USD 534 billion from the value of leading US corporations in the S&P 500 from 2014 to 2019 (Luo 2021). Thus, it is difficult to overstate the importance of the ESG controversy. Furthermore, ESG controversies matter a great deal according to legitimacy theory (Suchman 1995), stakeholder theory (Donaldson and Preston 1995; Godfrey et al. 2009; Kacperczyk 2009; Aouadi and Marsat 2018), and agency theory (Jensen and Meckling 1976). As relatively little research exists on ESG controversies, we fill this gap by exploring how ESG controversies are influenced by the takeover market.¹

The takeover market, often known as the market for corporate control, has long been recognized as one of the most important external governance mechanisms (Manne 1965; Fama 1980; Fama and Jensen 1983; Lel and Miller 2015; Cain, McKeown, and Solomon 2017). Substantial research has been conducted on the effects of the takeover market on a broad range of corporate policies, strategies, and outcomes. For instance, prior studies have examined the effects of the takeover market and found that stronger takeover vulnerability brings about higher productivity and profitability (Bertrand and Mullainathan 2003); more corporate risk-taking (Low 2009); higher leverage (Garvey and Hanka 1999); higher managerial ownership; less powerful executive risk-taking incentives (Ongsakul et al. 2020); lower board gender diversity, larger board size, and lower board independence (Chatjuthamard et al. 2021); anda stronger culture of corporate integrity (Ongsakul et al. 2021).

We offer two competing hypotheses on the effect of the takeover market on ESG. The agency cost reduction hypothesis asserts that increased takeover threats result in fewer ESG controversies. According to this view, the disciplinary mechanisms of the takeover market mitigate agency problems and encourage managers to avoid ESG controversies, which have been shown to diminish shareholder value (Frooman 1997; Klassen and McLaughlin 1996; Luo 2021). The managerial myopia hypothesis contends that companies more susceptible to hostile takeovers engage in more ESG controversies. Managerial myopia is exacerbated by an active takeover market, because managers are less secure in terms of employment when facing more takeover threats. Thus, they may participate in controversial activities that boost short-term outcomes, but have negative long-term effects.

To capture the extent of ESG controversies, we relied on data from Refinitiv. To gauge the degree of takeover vulnerability, we employ a novel measure of takeover susceptibility based on the staggered adoption of state legislation, which is plausibly exogenous.² Based on a large sample of U.S. firms, our results support the agency cost hypothesis, showing that greater takeover susceptibility brings about significantly fewer ESG controversies. Companies are involved in fewer ESG controversies when their managers are subjected to more takeover threats, which mitigate agency conflicts. In terms of economic magnitude, an increase in takeover susceptibility by one standard deviation diminishes ESG controversy by 10.12%.

We also examined how ESG controversies affect profitability. According to the legitimacy, stakeholder, and agency theories, ESG controversies are expected to affect firm performance (Suchman 1995; Donaldson and Preston 1995; Godfrey et al. 2009; Kacperczyk 2009; Aouadi and Marsat 2018; Jensen and Meckling 1976). Our results demonstrate that firm profitability declines significantly when firms are involved in more ESG controversies, which is consistent with theoretical predictions. Specifically, when ESG controversies increase by one standard deviation, firm profitability decreases by 3.51% after controlling for other firm-specific attributes. Finally, our analysis reveals that firm-specific risk increases significantly in response to ESG controversies, and an increase in ESG controversies by one standard deviation results in a 2.43% increase in idiosyncratic risk after accounting for other firm-specific characteristics. Crucially, our findings support prior research documenting an adverse impact on firm performance in response to ESG controversies (Frooman 1997; Klassen and McLaughlin 1996). Finally, ESG engagement is not related to ESG controversies, implying that socially responsible firms are as likely to participate.

Our results are unlikely to be affected by endogeneity, because our measure of takeover susceptibility is plausibly exogenous (Cain, McKeown, and Solomon 2017). Importantly, we controlled for firm fixed effects, which mitigated the endogeneity bias ascribed to unobserved heterogeneity. Nevertheless, we conducted various robustness checks to reduce endogeneity further. Specifically, we perform propensity score matching, entropy balancing, and instrumental variable analysis. The findings survived all robustness checks and were therefore unlikely to be contaminated by endogeneity.

The motivation behind our research is multifaceted, drawing on both theoretical frameworks and practical considerations to explore under-researched areas of ESG controversy. Theoretically, ESG controversies present fertile ground for analyses using various established theories. Legitimacy theory (Suchman 1995) explores how organizations seek to establish legitimacy in the eyes of stakeholders, whereas stakeholder theory (Donaldson and Preston 1995; Godfrey et al. 2009; Kacperczyk 2009; Aouadi and Marsat 2018) examines the impact of corporate actions on different stakeholder groups. Agency theory (Jensen and Meckling 1976), on the other hand, concentrates on the conflicts between managers and shareholders. Despite the rich theoretical landscape offered by these frameworks, there is a conspicuous gap in the literature on ESG controversies. This oversight is striking, given the increasing emphasis on sustainable and ethical corporate practices globally. Our research aims to bridge this gap by applying robust theoretical lenses to better understand and analyze ESG controversies.

From a practical standpoint, our study’s motivation is underscored by substantial empirical evidence showing the negative impact of ESG controversies on firm value and shareholder wealth (Luo 2021). These controversies do not exist in a vacuum; they have tangible and significant financial consequences that ripple across a wide spectrum of stakeholders, including shareholders, managers, regulators, and investors. In today's business environment, where corporate actions are scrutinized for their ethical and sustainable impacts, understanding the nature and implications of ESG controversies is imperative. Despite its evident financial and societal importance, there is a surprising scarcity of focused ESG research. This gap in the literature signifies a crucial area of exploration that our study seeks to address comprehensively.

By investigating the dynamics of ESG controversies and their broader implications, this study aims to provide valuable insights to guide stakeholders in making informed decisions. These insights are essential for developing effective strategies to manage and mitigate the impacts of ESG controversies, thereby enhancing corporate responsibility and sustainability. Through our study, we endeavor to deepen our understanding of ESG controversies, linking theoretical perspectives with practical realities, thereby advancing knowledge in this vital area of corporate governance and ethical business practice.³

Our research makes significant contributions to various important fields by enhancing our understanding of corporate practices and governance. First, it addresses a notable gap in the existing body of research. While many studies focus on corporate CSR/ESG performance, there is a striking lack of research that specifically examines ESG controversies. Oversight is crucial in a business environment that is increasingly focusing on sustainability and ethics. Our pioneering research is the first to systematically explore the influence of the corporate control market on ESG controversies. This not only fills a critical void in the literature, but also sets the stage for further scholarly investigations of this pertinent issue.

Second, our findings contribute significantly to corporate governance literature. The role of the takeover market as an external governance mechanism is well-established and is known to impact a wide array of corporate outcomes. This has been evidenced in the works of several researchers, such as Bertrand and Mullainathan (2003), Low (2009), Garvey and Hanka (1999), and others, including Cheng, Nagar, and Rajan, and more recent studies by Ongsakul et al. (2020) and Chatjuthamard et al. (2021). Our study builds on this existing knowledge by revealing how the takeover market can significantly impact ESG controversies. In doing so, we add a new understanding of the complex dynamics of corporate governance, particularly in the context of ethical and sustainable business practices.

Third, our study confirms previous research (Frooman 1997; Klassen and McLaughlin 1996) by showing that ESG controversies significantly reduce firms’ profitability, highlighting their real financial impact. We also contribute to the understanding of corporate risk-taking (Low 2009; Chaivisuttangkun and Jiraporn 2021; Lee et al. 2021; Jiraporn and Lee 2017), revealing that ESG controversies escalate firm-specific risk. Consistent with the legitimacy, stakeholder, and agency theories (Suchman 1995; Palazzo and Scherer 2006; Donaldson and Preston 1995; Godfrey et al. 2009; Jensen and Meckling 1976), our findings indicate that ESG controversies impact both profitability and risk. Furthermore, our results do not suggest that takeover threats promote short-termism or motivate managers to engage in controversial activities that improve short-term benefits, thus challenging the managerial myopia hypothesis (Bhojraj and Libby 2005; Laverty 1996, 2004). Finally, our use of the hostile takeover index as an exogenous measure (Cain, McKeown, and Solomon 2017; Ongsakul et al. 2020, 2021; Chatjuthamard et al. 2021) adds to the growing area of research on takeover susceptibility.

II. Related literature and hypothesis development

a. ESG controversies

According to the literature, at least three theories are germane to ESG controversies: legitimacy, stakeholder, and agency theories. First, according to legitimacy theory, the ESG controversy is crucial. Corporate legitimacy is critical to a firm’s long-term viability. According to Suchman (1995), legitimacy is the widely held view or assumption that an entity’s acts are desirable, legitimate, or suitable within a socially formed system of norms, values, beliefs, and definitions (Aouadi and Marsat 2018). When companies are involved in controversial issues, they are deemed to lack acceptable legitimacy, and their organizational legitimacy is questioned (Palazzo and Scherer 2006; Aouadi and Marsat 2018). Accusations of questionable behavior have a detrimental effect on a company’s brand and reputation (Donaldson and Preston 1995; Aouadi and Marsat 2018).⁴

According to the stakeholder theory, socially responsible actions increase a company’s value by fostering favorable interactions with stakeholders (Donaldson and Preston 1995; Godfrey et al. 2009; Kacperczyk 2009; Aouadi and Marsat 2018). In comparison, controversial activitiesexacerbate stakeholder distrust and perceptions of corporate duplicity (Aouadi and Marsat 2018), resulting in diminished credibility (Godfrey et al. 2009; Aouadi and Marsat 2018).⁵

Finally, agency theory suggests that managers acting as agents for shareholders may not always act in the shareholders’ best interestsbecause of agency problems (Jensen and Meckling 1976). Agency conflicts arise when managers’ incentives do not align with those of the shareholders. It is conceivable that self-interested managers may have the firm engage in controversial activities to enhance their private benefits at the expense of their shareholders. However, corporate governance mitigates agency conflicts and aligns shareholder and manager interests into better alignment. Prior research has used agency theory to explore the effects of corporate governance on ESG/CSR performance (Jo and Harjoto 2012; Jain and Jamali 2016; Chintrakarn et al. 2016; Chintrakarn et al. 2020; Chintrakarn, Jiraporn, and Treepongkarun 2021).⁶

While the literature is teeming with studies that focus on socially responsible actions, research on ESG is relatively scarce. Most studies have examined the relationship between ESG controversies, and firm valuation (Aouadi and Marsat 2018; Klassen and McLaughlin 1996)or stock returns (Dorfleitner, Kreuzer, and Sparrer 2020; de Franco 2020). Other studies investigated the moderating role played by ESG controversies in the relationship between ESG performance and firm financial performance shortfall (DasGupta 2021) or financial risk (Shakil 2021). Recent studies have highlighted the effects of internal (Treepongkaruna, Kyaw, and Jiraporn 2024) and external governance (Treepongkaruna, Kyaw, and Jiraporn 2022) on ESG controversies.

b. Corporate governance and the market for corporate control

According to the literature, the market for corporate control, frequently referred to as the takeover market, is a critical external disciplinary mechanism for corporate governance (Manne 1965; Fama 1980; Fama and Jensen 1983; Lel and Miller 2015; Cain et al. 2017; Ongsakul, Chatjuthamard, and Jiraporn 2021; Ongsakul et al. 2020). Many studies have examined changes in takeover susceptibility by examining variations in specific takeover defenses or anti-takeover legislation (Bertrand and Mullainathan 2003; Schwert 2000; Karpoff and Malatesta 1989). Nonetheless, a key shortcoming of prior research in this field is its exclusive focus on a single or limited number of anti-takeover statutes (Cain et al. 2017).

To address the problems raised in previous research, Cain et al. (2017) developed a hostile takeover indexbased primarily on the staggered adoption of 17 takeover statutes passed between 1965 and 2014. Using this innovative measure of takeover susceptibility, they show that stronger takeover protection reduces company value, supporting the managerial entrenchment and agency cost arguments. Their findings are noteworthy not only because they represent a substantial step toward addressing endogeneity but also because they cover the whole spectrum of state laws (Cain et al. 2017; Ongsakul, Chatjuthamard, and Jiraporn 2021; Ongsakul et al. 2020).

The takeover index has recently increased in popularity and has been used in several studies. According to Ongsakul et al. (2021), a higher degree of takeover vulnerability, as defined by the takeover index, leads to greater corporate integrity when corporate integrity is measured using a novel metric obtained from cutting-edge machine learning techniques. Similarly, Chatjuthamard et al. (2021) used a new proxy for corporate complexity based on textual analysis to show a considerable decline in corporate complexity in response to greater takeover vulnerability. According to them, increased takeover susceptibility exacerbates managerial myopia, leading to fewer long-term and less complex investments.

Furthermore, according to Ongsakul, Chatjuthamard, and Jiraporn (2021), higher takeover vulnerability diminishes innovation efficiency, as proxied by the research quotient (Cooper, Knott, and Yang 2021). In addition, hostile takeover threats have been found to have a significant influence on board governance because they alter crucial board characteristics, including board independence and gender diversity (Chatjuthamard et al. 2021).

c. Managerial short-termism

According to previous studies, managers may display myopic conduct (Bhojraj and Libby 2005; Graham et al. 2005; Laverty 1996, 2004; Lundstrum 2002; Mizik 2010). Numerous variables contribute to the development of managerial myopia, such as agency conflicts and information asymmetry (Bebchuk and Stole 1993; Lundstrum 2002; Mizik 2010; Narayanan 1985). Agency conflicts may occur when managers’ career horizons are shorter than those of their shareholders. Managers have little incentive to pursue earnings that may be realized beyond the end of their employment (Schuster et al. 2018; Ongsakul et al. 2021; Chatjuthamard et al. 2021).

Additionally, the stock market’s short-term orientation may increase managerial myopia in publicly traded companies (Bhojraj and Libby 2005; Schuster et al. 2018). Quarterly profit pressure and regular reporting add to managers’ short-termism (Laverty 2004). Managers plagued by myopia can adopt steps to boost short-term performance for personal gain, even if these activities eventually reduce shareholder value. Managers who are not expected to stay with a company for long periods, such as those approaching retirement or seekingnew positions, may emphasize short-term profits over long-term earnings. Consequently, managerial myopia can exacerbate agency conflicts (Ongsakul et al. 2021; Chatjuthamard, Ongsakul, and Jiraporn 2021).

d. Hypothesis development

Based on the literature, we propose the following two competing hypotheses: Theagency cost reduction hypothesis argues that greater takeover threats result in fewer ESG issues. According to this view, the disciplinary mechanism associated with the takeover market mitigates agency problems and motivates managers to avoid engaging in ESG controversies that reduce firm value (Frooman 1997; Klassen and McLaughlin 1996). Consistent with this view, Cain et al. (2017) reported that a higher degree of takeover vulnerability raises firm value, suggesting that hostile takeover threats represent a disciplinary mechanism that alleviates agency problems. Similarly, Ongsakul et al. (2021) demonstrated that more takeover threats significantly enhance a corporate culture of integrity, implying thattakeover vulnerability leads to more positive outcomes. Therefore, this hypothesis predicts that more takeover threats result in fewer ESG controversies.

In contrast, the managerial myopia hypothesis argues that companies that are more vulnerable to hostile takeovers tend to engage more in ESG controversies. A more active takeover market exacerbates managerial myopia because managers are less secure in their jobs when facing more takeover threats. Consequently, they may engage in controversial activities that improve their short-term results, although these pursuits may have adverse long-term consequences. Managerial entrenchment allows managers to retain their jobs for prolonged periods. This ongoing presence has ramifications for stakeholders: with a longer tenure, stakeholders are more likely to interact with the same management and corporate policies over a prolonged period. Problematic manager behavior nearly always encourages stakeholders to predict similar behavior in the future, as long as the same management team remains in place (Anderson and Reeb 2004; Jiraporn et al. 2012). Due to concerns about their reputations, entrenched managers are less inclined to participate in controversial activities. However, in a more active takeover market, this reputation mechanism is significantly weakened, as hostile takeovers threaten managers’ job security considerably. This view predicts that greater takeover vulnerability will result in more ESG controversy.

Consistent with managerial myopia, takeover vulnerability has recently been shown to worsen managerial short-termism, leading to significantly less innovation and lower corporate complexity (Ongsakul, Chatjuthamard, and Jiraporn 2021; Chatjuthamard, Ongsakul, and Jiraporn 2021).

III. Sample construction, data description, and methodology

a. Sample formation and data description

The data on ESG controversies come from Refinitiv. Cain, McKeown, and Solomon (2017) provided data on the hostile takeover index. COMPUSTAT provides firm-specific attributes. Outliers were removed at the 1% and 99% levels, where necessary. The final sample comprises an imbalanced panel dataset of 6,236 firm-year observations from 2002 to 2014. The ESG controversyscore is calculated based on 23 controversial ESG topics, with recent controversies reflected in the latest complete period.⁷ A percentile rank formula is applied to each industry group, and the score reflects the extent to which a firm engages in ESG controversies relative to its industry peers. Detailed information on the construction of the ESG controversy score is available.⁸ Board independence is the percentage of independent outside directors on a board.

b. Measuring hostile takeover vulnerability

To assess takeover susceptibility, we employ the hostile takeover index, consistent with recentstudies (Cain et al. 2017; Ongsakul et al. 2021). This index has a significant advantage because it is based on exogenous variables. The index comprises three parts: (1) legal determinants (the staggered adoption of 17 state laws governing takeovers), (2) macroeconomic factors (capital liquidity), and (3) company factors that are not affected by firm choice (firm age). A higher index value indicates greater takeover susceptibility. This metric was far less vulnerable to endogeneity than any other measure employed in previous studies.

Cain et al. (2017) created a firm-level takeover index based on the findings of their logistic regression analysis to predict the probability of hostile takeovers. Cain et al. (2017) went into further depth in constructing a takeover index. In the recent literature, the hostile takeover index has been frequently employed, demonstrating its practical usefulness (Cain, McKeown, and Solomon 2017; Ongsakul et al. 2020; Ongsakul et al. 2021; Chatjuthamard, Ongsakul, and Jiraporn 2021; Ongsakul et al. 2021; Chatjuthamard et al. 2021).

c. Additional variables and empirical modeling

Essentially, we estimated the following regression analysis: $\mathrm{ESG}\mathrm{Controversies}\mathrm{Scor}{\mathrm{e}}_{\mathrm{it}}=a+b(\mathrm{Hostile}\mathrm{Takeover}\mathrm{Index}{)}_{\mathrm{it}}+c(\mathrm{Controls}{)}_{\mathrm{it}}$where i indexes firms and t indexes years.

Based on previous research (Haque and Ntim 2020; Jiraporn et al. 2014; Jo and Harjoto 2012; Chintrakarn et al. 2016), we included many variables to account for other factors that may impact ESG controversies: firm size (Ln of total assets), profitability (EBIT/total assets), leverage (total debt/total assets), investments (capital tures/total assets), intangible assets (R&D/total assets and advertising expense/total assets), discretionary spending (SG&A expense/total assets), cash holdings (cash holdings/total assets), dividend payouts (dividends/total assets), and asset tangibility (fixed assets/total assets).

We included year-fixed effects to control for possible variations over time. Crucially, we include firm-fixed effects, which are important because they account for any unobservable characteristic that remains constant overtime. Finally, as more socially responsible companies are less likely to engage in contentious activities, we included Refinitiv’s ESG score to account for the level of ESG engagement. Table A1 in the Appendix summarizes the definitions of the variables. Table 1 presents summary statistics for the ESG controversy score, hostile takeover index, and firm-specific characteristics.

Table 1. Summary statistics.

	Mean	S.D.	25th	Median	75th
Environment, Social, and Governance (ESG)
ESG Controversies Score	82.924	29.214	75.000	100.000	100.000
ESG Score	38.334	19.478	23.115	34.315	51.330
Takeover Susceptibility
Hostile Takeover Index	0.192	0.106	0.109	0.168	0.273
Firm-specific Characteristics
Total Assets	16000.000	44000.000	2595.475	5258.250	12000.000
Total Debt/Total Assets	0.240	0.176	0.115	0.222	0.335
Capital expenditures/Total Assets	0.049	0.048	0.020	0.034	0.059
Advertising Expense/Total Assets	0.015	0.035	0.000	0.000	0.014
R&D Expense/Total Assets	0.029	0.053	0.000	0.004	0.035
Cash Holdings/Total Assets	0.150	0.147	0.042	0.101	0.209
Dividends/Total Assets	0.017	0.023	0.000	0.008	0.025
Fixed Assets/Total Assets	0.505	0.354	0.220	0.407	0.741
SG&A Expense/Total Assets	0.209	0.172	0.078	0.168	0.297
Profitability Measures
EBITDA/Total Assets	0.153	0.086	0.102	0.145	0.197
EBIT/Total Assets	0.112	0.084	0.065	0.105	0.155
ROA (Net Income/Total Assets)	0.059	0.088	0.030	0.063	0.102

The ESG controversies score is provided by Refinitiv. A high value of the score indicates fewer ESG controversies, relative to the industry peers. The hostile takeover index is constructed by Cain, McKewon, and Solomon (2017) primarily based on the staggered adoption of state legislations. A higher value of the takeover index suggests higher takeover vulnerability. The ESG score is also provided by Refinitiv. A higher value indicates more ESG activities. Total assets are in millions.

IV. Results

a. Baseline regression analysis

Table 2 reports the firm-fixed-effects regression results where the dependent variable is the ESG controversies score (the higher the score, the fewer ESG controversies the firm participates in). The standard errors are clustered by firm and year. Model 1 has the hostile takeover index as the only independent variable, whereas Model 2 includes all the control variables. The coefficients of the hostile takeover index are positive and significant in both regressions. The results corroborate the agency cost reduction hypothesis, where the disciplinary mechanism associated with the takeover market encourages managers to take steps that benefit shareholders in the long term, including avoiding ESG controversies. Notably, our findings aptly align with those by Cain, McKeown, and Solomon (2017), who found that a higher level of takeover susceptibility enhances firm value, validating the prediction of the arguments based on managerial entrenchment and agency conflicts. It is noteworthy that the coefficient of the ESG score is not significant, implying that more socially responsible firms are not any less likely to engage in controversial activities.

Table 2. The effect of hostile takeover vulnerability on ESG controversies.

	(1)	(2)
	ESG Controversies Score	ESG Controversies Score
Hostile Takeover Index	30.350***	27.897***
	(4.213)	(4.612)
Firm Size		−1.889
		(−1.237)
Leverage		1.291
		(0.297)
Profitability		23.173**
		(2.717)
Capital Investments		9.195
		(0.532)
Advertising Intensity		−40.102
		(−0.895)
R&D Intensity		22.930
		(1.197)
Cash Holdings		−3.539
		(−0.599)
Dividend Payouts		6.249
		(0.192)
Asset Tangibility		−2.200
		(−0.430)
Discretionary Spending		−9.881
		(−0.802)
ESG Score		−0.103
		(−1.560)
Constant	77.080***	98.146***
	(57.889)	(6.213)
Firm Fixed Effects	Yes	Yes
Year Fixed Effects	Yes	Yes
Observations	6,226	6,226
Adjusted R-squared	0.339	0.341

Robust t-statistics in parentheses.

*** p < 0.01, ** p < 0.05, * p < 0.1.

The ESG controversies score is provided by Refinitiv. A high value of the score indicates fewer ESG controversies, relative to the industry peers. The hostile takeover index is constructed by Cain, McKewon, and Solomon (2017) primarily based on the staggered adoption of state legislations. A higher value of the takeover index suggests higher takeover vulnerability. The ESG score is also provided by Refinitiv. A higher value indicates more ESG activities.

Regarding the economic significance, we estimate the magnitude of the takeover market’s effect on ESG controversies as follows: The coefficient of the takeover index was 27.897 and the standard deviation of the index was 0.106. Therefore, an increase in takeover susceptibility by one standard deviation increases the ESG controversy score by 0.106 × 27.897, which is 2.957. As one standard deviation of the ESG controversy score is 29.214, an increase of 2.957 represents a 10.12% increase. Not only is the effect of the takeover market statistically significant but it is also economically meaningful.

Crucially, because we include firm fixed effects in our regression analysis, our results are unlikely to have been contaminated by endogeneity bias, which can be attributed to unobservable firm characteristics. Moreover, because our proxy for takeover vulnerability is principally based on the staggered passage of state legislation, which is plausibly exogenous (Cain, McKewon, and Solomon 2017), our findings may reflect causal influence rather than mere correlation.

b. Propensity score matching

Although endogeneity was unlikely, we executed further robustness checks to mitigateit. We validate our findings using propensity score matching (Rosenbaum and Rubin 1983; Lennox, Francis, and Wang 2011). The sample is divided into quartiles using a hostile takeover index. The treatment group comprises observations within the top quartile of distribution (the highest takeover vulnerability). For each observation in the treatment group, we selected the most comparable observation from the remainder of the sample based on the 11 company characteristics (i.e. the 11 control variables included in the regression analysis). Therefore, apart from takeover susceptibility, the treatment and control groups were nearly identical for every observable parameter. We adopted one-to-one matching with the nearest-neighbor method with replacement.

Diagnostic testing was conducted to confirm matching accuracy. The results are summarized in Table 3 Panel A. Model 1 is a logistic regression with a binary dependent variable equal to one if the company is in the treatment group (more takeover susceptibility) and zero otherwise. This includes the entire sample (pre-matching). This finding indicates that the treatment firms differ significantly from the rest of the sample in several ways. In particular, firms in the treatment group are larger, have less capital expenditure, hold less cash, pay larger dividends, and take more socially responsible actions. We must account for these material differences because they may have biased the results.

Table 3. Propensity score matching.

Panel A: Diagnostic testing
	(1)	(2)
	Pre-Match	Post-Match
	Treatment (High Takeover Vulnerability)	Treatment (High Takeover Vulnerability)
Firm Size	0.286***	0.016
	(3.108)	(0.168)
Leverage	−0.666	−0.325
	(−1.347)	(−0.551)
Profitability	−1.542	−0.006
	(−1.516)	(−0.005)
Capital Investments	−5.516**	−1.135
	(−2.180)	(−0.441)
Advertising Intensity	2.036	1.292
	(0.752)	(0.373)
R&D Intensity	−1.654	0.471
	(−0.794)	(0.146)
Cash Holdings	−2.708***	0.168
	(−3.572)	(0.187)
Dividend Payouts	10.903***	−2.790
	(3.303)	(−0.700)
Asset Tangibility	0.351	−0.178
	(1.057)	(−0.485)
Discretionary Spending	−0.224	−0.451
	(−0.329)	(−0.611)
ESG Score	0.016***	0.001
	(4.143)	(0.132)
Constant	−3.684***	0.160
	(−4.290)	(0.176)
Pseudo R-squared	0.105	0.004
Observations	6,236	3,118
Robust z-statistics in parentheses.
*** p < 0.01, ** p < 0.05, * p < 0.1.
Panel B: Regression analysis with propensity score matching
	(1)
	ESG Controversies Score
Hostile Takeover Index	18.071**
	(2.641)
Firm Size	−5.047
	(−1.687)
Leverage	6.233
	(0.704)
Profitability	41.566**
	(2.308)
Capital Investments	33.784
	(0.982)
Advertising Intensity	11.197
	(0.127)
R&D Intensity	89.780
	(1.004)
Cash Holdings	1.684
	(0.140)
Dividend Payouts	82.087*
	(1.900)
Asset Tangibility	2.438
	(0.291)
Discretionary Spending	−64.493**
	(−2.391)
ESG Score	−0.026
	(−0.248)
Constant	121.071***
	(4.051)
Firm Fixed Effects	Yes
Year Fixed Effects	Yes
Observations	3,003
Adjusted R-squared	0.419

The ESG controversies score is provided by Refinitiv. A high value of the score indicates fewer ESG controversies, relative to the industry peers. The hostile takeover index is constructed by Cain, McKewon, and Solomon (2017) primarily based on the staggered adoption of state legislations. A higher value of the takeover index suggests higher takeover vulnerability. The ESG score is also provided by Refinitiv. A higher value indicates more ESG activities.

Robust t-statistics in parentheses.

*** p < 0.01, ** p < 0.05, * p < 0.1.

Model 2 was a logistic regression model created for the PS-matched sample (post-matched). None of the coefficients in Model 2 are significant; thus, our treatment and control companies are statistically identical in all observable aspects. Our treatment and control firms should have comparable ESG controversies, to the extent that takeover susceptibility is immaterial. Panel B of Table 3 presents the regression results for the propensity score-matched sample. The coefficient of the hostile takeover index remains significantly positive, validating the agency cost-reduction hypothesis. Our conclusion does not appear to be primarily driven by endogeneity based on the consistency of our propensity score matching (PSM) findings.⁹

c. Entropy balancing

Previous studies relied criticallyon the concept of observable selection. To circumvent this assumption, we use Hainmueller’s (2012) entropy balancing methodology, which is a variation of conventional matching algorithms. In particular, entropy balancing achieves a high degree of covariate balance by including the covariate balance directly in the weight function applied to the sample units (Hainmueller 2012; Balima 2020). Hainmueller (2012) provided more details on entropy balancing. This novel matching approach has been widely used in recent studies (McMullin and Schonberger 2020; Wilde 2017; Neuenkirch and Tillmann 2016; Freier, Schumann, and Siedler 2015; Bol et al. 2020; Neuenkirch and Neumeier 2016; Glendening, Mauldin, and Shaw 2019; Truex 2014; Marcus 2013; Ongsakul et al. 2021; Chatjuthamard, Ongsakul, and Jiraporn 2021).

Thus, entropy balancing is achieved. For the treatment group, we chose companies whose takeover susceptibility was in the top quartile; the remaining sample was referred to as the control group. Subsequently, entropy balancing was used for all control variables to ensure that the means and variances of the observations in the two groups were comparable. Table 4 presents the regression results for the entropy-balanced samples. The coefficient on the hostile takeover index remainspositive and significant. Firms with a higher takeover susceptibility engage insignificantly fewer ESG controversies. The agency cost reduction hypothesis was again confirmed.

Table 4. Entropy balancing.

	(1)
	ESG Controversies Score
Hostile Takeover Index	16.990**
	(2.369)
Firm Size	−3.592
	(−1.366)
Leverage	7.107
	(0.896)
Profitability	39.423**
	(2.692)
Capital Investments	15.153
	(0.551)
Advertising Intensity	41.287
	(0.528)
R&D Intensity	76.967
	(0.603)
Cash Holdings	10.407
	(0.857)
Dividend Payouts	67.589
	(1.142)
Asset Tangibility	2.529
	(0.331)
Discretionary Spending	−42.105
	(−1.680)
ESG Score	−0.072
	(−0.909)
Constant	105.380***
	(3.858)
Firm Fixed Effects	Yes
Year Fixed Effects	Yes
Observations	6,226
Adjusted R-squared	0.394

Robust t-statistics in parentheses.

*** p < 0.01, ** p < 0.05, * p < 0.1.

The ESG controversies score is provided by Refinitiv. A high value of the score indicates fewer ESG controversies, relative to the industry peers. The hostile takeover index is constructed by Cain, McKewon, and Solomon (2017) primarily based on the staggered adoption of state legislations. A higher value of the takeover index suggests higher takeover vulnerability. The ESG score is also provided by Refinitiv. A higher value indicates more ESG activities.

d. Instrumental-variable analysis

To further mitigate endogeneity in our analysis, we employ an instrumental variable approach. Our chosen instrument is the average value of the hostile takeover index for all companies located in the same city. This choice was grounded in the rationale that companies nearly situated often experience similar economic conditions, which makes this measure pertinent. Moreover, the location of a company's headquarters, which often influences its exposure to these economic conditions, is typically established early in the firm's history and rarely changes over time. As Pirinsky and Wang (2006) suggested, this historical decision is likely to be exogenous to a firm’s current characteristics. Therefore, headquarters’ location is a reliable variable that is exogenous to contemporaneous firm characteristics while being uncorrelated with the error term in our regression model.

This methodological approach, which leverages geographic identification, has been increasingly recognized and utilized in the academic literature. It has been effectively applied in various studies such as Jiraporn et al. (2014), Chintrakarn et al. (2017), and Chintrakarn et al. (2015). These studies underscore the validity and acceptability of this approach for addressing endogeneity concerns. The regression results are presented in Table 5. Model 1 is a first-stage regression that uses the hostile takeover index as the dependent variable. As expected, the coefficient on the average takeover index for all firms in the same city is significantly positive. Model 2 is the second-stage regression, in which the ESG controversy scoreis the dependent variable. The hostile takeover index, instrumented in the first stage, has a significantly positive coefficient.

Table 5. Instrumental-variable analysis.

	(1)	(2)
	Hostile Takeover Index	ESG Controversies Score
Hostile Takeover Index (City-average)	0.454***
	(10.161)
Hostile Takeover Index (Instrumented)		56.186**
		(2.074)
Firm Size	−0.001	−1.874
	(−0.874)	(−1.575)
Leverage	−0.004	1.290
	(−0.929)	(0.329)
Profitability	0.006	22.888***
	(1.400)	(3.337)
Capital Investments	0.001	9.627
	(0.130)	(0.617)
Advertising Intensity	0.047**	−41.486
	(2.183)	(−1.213)
R&D Intensity	−0.007	22.873
	(−1.042)	(1.478)
Cash Holdings	−0.008**	−3.214
	(−2.343)	(−0.626)
Dividend Payouts	0.053**	3.895
	(2.129)	(0.154)
Asset Tangibility	−0.003	−2.170
	(−0.721)	(−0.558)
Discretionary Spending	−0.008	−9.435
	(−1.025)	(−1.113)
ESG Score	−0.000	−0.101***
	(−0.964)	(−2.797)
Constant	0.095***	102.050***
	(6.709)	(8.133)
Firm Fixed Effects	Yes	Yes
Year Fixed Effects	Yes	Yes
Observations	6,236	6,236
Adjusted R-squared	0.961	0.474
Cragg-Donald Wald F statistic	1735.44***

Robust t-statistics in parentheses.

*** p < 0.01, ** p < 0.05, * p < 0.1.

The ESG controversies score is provided by Refinitiv. A high value of the score indicates fewer ESG controversies, relative to the industry peers. The hostile takeover index is constructed by Cain, McKeon, and Solomon (2017) primarily based on the staggered adoption of state legislations. A higher value of the takeover index suggests higher takeover vulnerability. The ESG score is also provided by Refinitiv. A higher value indicates more ESG activities.

For robustness, we performed an additional analysis using alternative model specifications. Specifically, we added two control variables that influenced the extent of takeover vulnerability. First, staggered boards are considered a takeover defense mechanism because it takes more time for the acquirer to replace most directors on the board when the board is staggered, thereby complicating takeover efforts (Cremers, Litov, and Sepe 2017;Amihud and Stoyanov 2017; Jiraporn and Liu 2008). We include a binary equal to one if the board is staggered and zero otherwise. Second, share repurchases can be used as a takeover defense by increasing the company's share price and reducing the number of available shares in the market, making a takeover bid more costly and difficult for potential acquirers (Bagwell 1991). Accordingly, we include share repurchases as a control variable (ratio of share repurchases to total assets). Table A2 in the Appendix presents the regression results. Notably, the coefficient of the hostile takeover index instrumented from the first stage remained significantly positive. As the instrumental variable (IV) results remain consistent, it is unlikely that our conclusions will be affected by endogeneity.

e. Regression analysis with additional control variables

To enhance the robustness of our findings, we conduct a regression analysis using additional control variables. First, we considered internal governance factors by including board-related variables such as board size, board independence (percentage of independent directors), board gender diversity (percentage of female directors), and board ethnic diversity (percentage of ethnic minority directors) as the board of directors is commonly recognized as a crucial internal governance mechanism (Weir, Laing, and McKnight 2002; Kyaw et al. 2020). Second, we acknowledge institutional ownership as another significant governance mechanism because of the monitoring role of large institutional shareholders (Kang, Luo, and Na 2018; Kyaw, Thomsen, and Treepongkaruna 2022). Moreover, to account for industry-specific variations, we incorporate industry-level variables based on the first two SIC digits. These variables include industry competition (measured by the Herfindahl Index based on market share), industry-average profitability (industry-average ratio of EBIT to total assets), and industry-level leverage (industry-average ratio of total debt to total assets).

Appendix Table A3 presents the regression results. Remarkably, the coefficient of the hostile takeover index remains significantly positive, confirming that increased vulnerability to takeovers results in fewer ESG controversies. Our conclusions remain robust even after expanding our set of control variables to include board characteristics, institutional ownership, and industry-level variables.

f. The effect of ESG controversies on corporate profitability

This section explores the effects of ESG controversies on profitability and firm risk. The motivation to study the impact of ESG controversies on firm profitability and risk is well-founded in several key theoretical frameworks. These theories suggest that ESG controversies can significantly undermine a firm's performance and increase its risk profile. Legitimacy theory posits that controversies adversely affect a company's brand and image (Donaldson and Preston 1995; Aouadi and Marsat 2018). When a company is embroiled in an ESG controversy, its legitimacy is compromised in the eyes of stakeholders, leading to a potential decline in customer loyalty, investor confidence, and overall brand value. This erosion of brand and image can directly affect profitability, as customers and investors may choose to dissociate from the firm.

The stakeholder theory further emphasizes the importance of ESG issues, arguing that controversial business practices can lead to stakeholder distrust and perceptions of corporate deception (Du et al. 2010; Maignan and Ralston 2002; Aouadi and Marsat 2018). This erosion of trust can have serious financial implications, as stakeholders, including customers, employees, and investors, may withdraw their support, leading to a decline in sales, productivity, and investment. Moreover, agency theory raises concerns about the management's role in ESG controversies, suggesting that self-interested actions by management could lead to decisions that harm the company while benefiting individual managers (Jensen and Meckling 1976). Such actions can cause significant financial and reputational damage to the firm, thereby increasing firm risk and potentially harming long-term shareholder value.

Given these theoretical perspectives, it is imperative to empirically investigate the extent to which ESG controversies affect firms’ profitability and risk. This is particularly relevant in the context of our analysis of the takeover market’s effect on ESG controversies. Understanding the impact of ESG controversies on firm performance not only contributes to academic discourse, but also provides practical insights for managers, investors, and policymakers on the consequences of failing to adhere to ESG principles. Therefore, our study tests the hypothesis that an increase in ESG controversies is associated with an increase in firm risk and anticipates a negative impact on profitability, in line with theoretical predictions.

We employed four alternative proxies to capture corporate profitability. First, as in Dewenter and Malatesta (2001), we use return on assets (ROA), which is net income divided by total assets. Second, we use the EBIT and EBITDA ratios, which are EBIT and EBITDA divided by total assets, respectively, as Nissim (2019) suggested. These three ratios measure profitability along different dimensions, either at the operating or bottom level. Thus, following Zeli and Mariani (2009), we combine these three ratios to construct a profitability index. For this purpose, we used the first component from the principal component analysis. By focusing only on the three common profitability ratios, we can reduce the measurement errors to the extent that they are not correlated.

The regression results are presented in Table 6. The coefficients of ESG controversy were all significantly positive in all regressions. As a higher ESG controversy score is associated with fewer controversies, a positive coefficient reveals that fewer ESG controversies raise firm profitability significantly, which is consistent with the theoretical predictions. In terms of economic significance, we estimate the magnitude of ESG controversies regarding profitability as follows: The coefficient of ESG controversy in Model 4 is 0.219 and the standard deviation of ESG controversies is 29.214; thus, an increase in the ESG controversy score by one standard deviation raises profitability by 0.219× 29.214, which is 6.398. Because the standard deviation of the profitability index is 163.864, an increase in the ESG controversy score by one standard deviation boosts a firm’s profitability by 3.904% (6.398 divided by 163.864).

Table 6. The effect of ESG controversies on profitability.

	(1)	(2)	(3)	(4)
	ROA	EBIT/Total Assets	EBITDA/Total Assets	Profitability Index
ESG Controversies Score	0.019***	0.009**	0.012**	0.219***
	(3.939)	(3.050)	(2.997)	(4.180)
Firm Size	−0.029**	−0.020***	−0.016	−0.362**
	(−2.357)	(−3.614)	(−1.301)	(−2.468)
Leverage	−0.144**	−0.062***	−0.099**	−1.641***
	(−2.941)	(−3.887)	(−2.197)	(−3.111)
Capital Investments	0.126	0.222***	0.141	2.908*
	(1.418)	(3.262)	(1.278)	(2.084)
Advertising Intensity	−0.036	0.017	0.060	0.274
	(−0.108)	(0.066)	(0.168)	(0.053)
R&D Intensity	−0.625***	−0.144	−0.345*	−5.771**
	(−4.129)	(−1.653)	(−1.787)	(−2.893)
Cash Holdings	0.012	0.002	−0.024	−0.045
	(0.315)	(0.089)	(−0.693)	(−0.093)
Dividend Payouts	0.708***	0.784***	0.976**	14.024***
	(3.635)	(5.333)	(3.031)	(4.115)
Asset Tangibility	−0.104***	−0.090***	−0.046	−1.356***
	(−3.633)	(−5.419)	(−1.427)	(−3.459)
Discretionary Spending	−0.033	0.092**	0.115	1.102
	(−0.537)	(2.491)	(1.769)	(1.299)
ESG Score	−0.000	0.000	−0.000	−0.001
	(−1.082)	(0.038)	(−0.055)	(−0.426)
Constant	0.399***	0.295***	0.299**	3.658**
	(3.360)	(5.375)	(2.436)	(2.537)
Firm Fixed Effects	Yes	Yes	Yes	Yes
Year Fixed Effects	Yes	Yes	Yes	Yes
Observations	6,226	6,226	6,224	6,224
Adjusted R-squared	0.385	0.696	0.593	0.616

Robust t-statistics in parentheses.

*** p < 0.01, ** p < 0.05, * p < 0.1.

The ESG controversies score is provided by Refinitiv. A high value of the score indicates fewer ESG controversies, relative to the industry peers. The hostile takeover index is constructed by Cain, McKeon, and Solomon (2017) primarily based on the staggered adoption of state legislations. A higher value of the takeover index suggests higher takeover vulnerability. The ESG score is also provided by Refinitiv. A higher value indicates more ESG activities. For ease of interpretation, we divide the ESG controversies score by 100.

Notably, our findings are similar to those of previous studies. For instance, according to Frooman’s (1997) meta-analysis, the stock market reacts unfavorably when a corporation engages in socially irresponsible or suspected social conduct. Similarly, Johnson showed that illicit CSR activities have detrimental effects on financial performance. Klassen and McLaughlin (1996) examined 22 adverse ESG news items (e.g. gas leaks and oil spills) and conclude that unfavorable stock returns are associated with negative ESG-related articles (Aouadi and Marsat 2018).

g. The effect of ESG controversies on firm risk

This theory suggests that ESG controversies hurt firm performance. This prediction is consistent across legitimacy theory (Suchman 1995), stakeholder theory (Donaldson and Preston 1995; Godfrey et al. 2009; Kacperczyk 2009; Aouadi and Marsat 2018), and agency theories (Jensen and Meckling 1976). These theoretical considerations suggest that the ESG controversy has exacerbated firm risk. In this section, we test the hypothesis that firm risk increases with increasing ESG controversy.

We measure firm-specific risk as follows: Daily stock returns are regressed against daily market returns, and the standard deviation of the regression residualsiscalculated. This variable captures idiosyncratic risk by excluding the influence ofbroad market risk (Chaivisuttangkun and Jiraporn 2021; Lee et al. 2021; Jiraporn and Lee 2017). Table 7 presents the regression results where the dependent variable is a firm-specific risk. The coefficient of ESG controversy was significantly negative. As a higher ESG controversy score implies fewer controversies, companies involved in fewer controversies experience significantly lower risk. More controversies exacerbate firm risk, corroborating the predictions of legitimacy, stakeholder, and agency theories.

Table 7. The effect of ESG controversies on firm-specific risk.

	(1)
	Firm-Specific Risk
ESG Controversies Score	−0.010*
	(−1.834)
Firm Size	−2.860**
	(−2.466)
Leverage	5.737*
	(1.930)
Profitability	−27.884***
	(−3.737)
Capital Investments	−2.104
	(−0.213)
Advertising Intensity	24.683
	(1.164)
R&D Intensity	0.545
	(0.071)
Cash Holdings	3.108
	(1.117)
Dividend Payouts	−61.239**
	(−3.031)
Asset Tangibility	1.096
	(0.350)
Discretionary Spending	5.345
	(1.001)
ESG Score	0.008
	(0.501)
Constant	52.550***
	(4.801)
Firm Fixed Effects	Yes
Year Fixed Effects	Yes
Observations	3,758
Adjusted R-squared	0.728

Robust t-statistics in parentheses.

*** p < 0.01, ** p < 0.05, * p < 0.1.

Daily stock returns are regressed against daily market returns. Then, we calculate the standard deviation of the regression's residuals. This variable captures idiosyncratic risk by excluding the influence of broad market risk The ESG controversies score is provided by Refinitiv. A high value of the score indicates fewer ESG controversies, relative to the industry peers. The hostile takeover index is constructed by Cain, McKewon, and Solomon (2017) primarily based on the staggered adoption of state legislations. A higher value of the takeover index suggests higher takeover vulnerability. The ESG score is also provided by Refinitiv. A higher value indicates more ESG activities.

In terms of economic significance, we estimate the effect of the ESG controversy on idiosyncratic risk as follows: The coefficient of ESG controversy in Table 7 was −0.010. The standard deviation of ESG controversies was 29.214. An increase in the ESG controversy score (fewer controversies) by one standard deviation reducesidiosyncratic risk by 29.214 × 0.010, which is 2.921. Because one standard deviation of idiosyncratic risk is 12.025, a drop of 2.921 is equivalent to a 2.43% decline in firm-specific risk after accounting for other firm-specific attributes.

V. Conclusions

In sharp contrast to the immense volume of research on ESG/CSR performance, ESG controversies have generated substantially less research, although ESG controversies have been shown to impair corporate value (Frooman 1997; Klassen and McLaughlin 1996; Luo 2021). Furthermore, ESG controversies have been recognized as important by legitimacy theory (Suchman 1995), stakeholder theory (Donaldson and Preston 1995; Godfrey et al. 2009; Kacperczyk 2009; Aouadi and Marsat 2018), and agency theory (Jensen and Meckling 1976).

We address this important gap in the literature by investigating how ESG controversies are influenced by the takeover market, which is widely acknowledged as a crucial instrument of external governance (Manne 1965; Fama 1980; Fama and Jensen 1983; Lel and Miller 2015; Cain, McKeown, and Solomon 2017). Two opposing hypotheses were proposed. The agency cost reduction hypothesis argues that the pressure associated with the takeover market prevents opportunistic managers from taking dubious actions and compels them to take actions that align with shareholder interests, such as avoiding ESG controversies. By contrast, the managerial myopia hypothesis suggests that an active takeover market threatens managers’ job security, motivating them to act myopically and participate in controversial activities that may improve firm performance in the short term.

By exploiting a unique measure of takeover susceptibility principally based on the staggered enactment of state legislation, we show that more takeover threats result in significantly fewer ESG controversies, reinforcing the agency cost-reduction hypothesis. In particular, an increase in takeover vulnerability by one standard deviation diminishes ESG controversy by 10.12%. The takeover market’s effect on ESG controversies is statistically significant and economically palpable. Endogeneity is unlikely to have tainted our findings as we relied on a distinctive measure of takeover vulnerability based on exogenous factors. We ran a variety of robustness checks, namely, propensity score matching, entropy balancing, and instrumental variable analysis. All robustness checks validated the findings, suggesting that they are unlikely to be contaminated by endogeneity and therefore probably reflect a causal effect rather than a mere association.

Moreover, we investigated the effects of ESG controversies on firm profitability. Consistent with the theoretical predictions, we document a substantial decline in firm profitability and a significant increase in firm-specific risk in response to more ESG controversy. Our findings are similar to those of prior studies that report an adverse effect of ESG controversies on firm performance (Frooman 1997; Klassen and McLaughlin 1996). Finally, our results demonstrate that ESG engagement is unrelated to ESG controversies, implying that socially responsible companies are no less likely to participate in these controversies.

The findings of our study not only extend the academic literature but also offer severalpractical ramifications for a broad range of stakeholders. First, investors, shareholders, and managers should be particularly cautious about engaging in controversial activities as they can have a detrimental impact on firm profitability. As our study establishes a link between ESG controversies and firm profitability, efforts should be made to avoid actions that may lead to such controversies. It is crucial to recognize that the consequences of ESG controversies extend beyond mere perception and can directly affect companies’ financial performance.

Second, regulators should consider our results, as we demonstrate that the takeover market, an external governance mechanism, plays a vital role in reducing ESG controversies. Our findings emphasize the importance of market discipline in curbing the opportunistic behavior of managers who prioritize their own private benefits over shareholders’ interests. When considering regulations aimed at preventing ESG controversies, regulators should consider the substantial role of markets in corporate control. Furthermore, shareholders of firms that are less subject to the pressure of the takeover market should exercise caution as they may have managers who are less restrained by market discipline and may thus participate in more contentious activities that ultimately harm firm performance. Shareholders should be mindful of the risks associated with such firms, and actively engage in monitoring and oversight to ensure responsible and sustainable practices.

Customers are expected to benefit from the results of this study. Knowledge of the relationship between the takeover market and the ESG controversy can influence customer choices and preferences. Customers who prioritize sustainability and ethical practices may favor companies with a lower incidence of ESG controversies. This information empowers consumers to make informed decisions and encourages companies to prioritize ESG considerations in order to attract and retain customers. Finally, non-governmental organizations (NGOs) and activist groups focusing on ESG issues can leverage this knowledge to advocate for improved corporate behavior and drive positive changes. Understanding the takeover market’s role in reducing ESG controversies allows them to identify areas of concern and engage with companies, shareholders, and policymakers to promote responsible practices.

The data on ESG controversies in this study are available from 2002, whilethe data on the takeover index are available until 2014. A key limitation of our study is the data coverage, which only extends up to 2014. This gap presents an opportunity for future research to enhance and update our findings using more recent data as it becomes available. Such an extension would be invaluable in ensuring that our insights remain relevant and reflective of the latest trends and changes in corporate governance and ESG practices.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Additional information

Funding

This project is funded by National Research Council of Thailand (NRCT): N42A640326.

Notes

1 ESG controversies refer to incidents or situations that raise concerns or criticisms related to a company's performance in ESG aspects. These controversies can include issues such as environmental damage, poor labor practices, unethical governance, or any other actions that conflict with sustainable and responsible business practices. Essentially, they are events or behaviors that negatively impact stakeholders' perception of a company's commitment to ESG principles.

2 State laws related to corporate takeovers play a crucial role in regulating how these acquisitions are conducted and managed. These laws vary significantly across states, each designed to protect shareholders and manage the process of changing company ownership. For example, Delaware, a popular state for corporate registrations, has statutes that provide flexibility to corporations in managing takeover bids, including the 'poison pill' strategy which allows existing shareholders to purchase additional shares at a discount to dilute the stake of the new acquirer. In contrast, states like Pennsylvania have more stringent anti-takeover laws, such as requiring a supermajority vote for mergers to be approved. California's laws focus on fairness in takeovers, ensuring that all shareholders are treated equally in a transaction. These laws create a diverse legal landscape that companies must navigate when considering mergers and acquisitions, significantly impacting the strategies and outcomes of corporate takeovers. A complete list of the state laws used in our study is available in Cain, McKeon, and Solomon (2017).

3 Our study diverges from two recent studies related to ESG controversies and the takeover market, which focus on different aspects. Zhu et al. (2023) investigate the impact of foreign acquirers' ESG misbehavior on cross-border acquisition completion, while Maung et al. (2021) examine the influence of a country's religiosity on cross-border mergers and acquisitions. Unlike these studies, our research zeroes in on domestic acquisitions. We distinctively analyze how takeover vulnerability, influenced by variations in state takeover laws, affects a company's involvement in ESG controversies. This approach sets our study apart, offering a novel perspective on the interplay between legal frameworks and corporate ESG conduct within the domestic context.

4 More research related to the legitimacy theory includes Archel et al. (2009), O’Donovan (2002), Guthrie and Parker (1989), Wilmshurst and Frost (2000), Luft Mobus (2005), and Deegan (2019),

5 Additional research on the stakeholder theory can be found in Friedman and Miles (2002), Phillips, Freeman, and Wicks (2003), Freeman (1999), Jones and Wicks (1999), Laplume, Sonpar and Litz (2008), and Pesqueux and Damak-Ayadi (2005).

6 Agency theory is also explored in the following studies: Tate et al. (2010), Nyberg et al. (2010), Bendickson et al. (2016), Bosse and Phillips (2016), and Pepper and Gore (2012).

7 The ESG Controversies Score is derived from an analysis of 23 ESG controversy topics. Throughout the year, any scandal involving a company results in penalties, directly impacting their overall ESG performance. The repercussions of such events can extend into the subsequent year, particularly if new developments arise, such as lawsuits, ongoing legislative disputes, or fines. We continuously capture new media materials to track the progression of each controversy. Additionally, our scoring method takes into account the market cap bias, a phenomenon where large-cap companies, due to their higher media visibility compared to smaller-cap firms, are more likely to be affected by negative publicity. This approach ensures a more equitable assessment across companies of different sizes.

8 More information about the construction of the ESG controversies score is available here: https://www.refinitiv.com/content/dam/marketing/en_us/documents/methodology/refinitiv-esg-scores-methodology.pdf

9 As a robustness check, we also perform an additional analysis where we match each observation in the treatment group with an observation in the bottom two quartiles. The result remains similar.

Appendix

Table A1. Variable definitions.

Variable	Definition
ESG
ESG Controversies Score	The ESG Controversies Score from Refinitiv indicates the percentile rank score
	of a firm’s engagement in ESG controversial activities relative to its industry
	peers. The higher the score, the fewer ESG controversies the firm engages in
ESG Score	The ESG Score from Refinitiv indicates the percentile rank score of a firm’s
	engagement in ESG activities relative to its industry peers. The higher
	the score, the more ESG activities the firm engages in
Hostile Takeover Exposure
Hostile Takeover Index	This index is constructed by Cain, McKeown, and Solomon (2017) based
	on state legislations, capital liquidity, and firm age
Firm-specific Characteristics
Firm Size	Total Assets
Leverage	Total Debt/Total Assets
Profitability	EBIT/Total Assets
Capital Investments	Capital Expenditures/Total Assets
Advertising Intensity	Advertising Expense/Total Assets
R&D Intensity	R&D Expense/Total Assets
Dividend Payouts	Dividends/Total Assets
Cash Holdings	Cash Holdings/Total Assets
Discretionary Spending	SG&A Expense/Total Assets
Asset Tangibility	Fixed Assets/Total Assets
Alternative Profitability Measures
EBITDA Ratio	EBITDA/Total Assets
ROA	Net Income/Total Assets

Table A2. Instrumental-variable analysis with additional control variables.

	(1)	(2)
	Hostile Takeover Index	ESGControversies Score
Hostile Takeover Index (City-average)	0.456***
	(3.904)
Hostile Takeover Index (Instrumented)		53.425**
		(1.969)
Firm Size	−0.002	−2.127*
	(−0.539)	(−1.745)
Leverage	−0.005	2.650
	(−0.654)	(0.658)
Profitability	0.002	23.613***
	(0.354)	(3.273)
Capital Investments	0.002	7.453
	(0.173)	(0.473)
Advertising Intensity	0.053	−45.798
	(1.069)	(−1.244)
R&D Intensity	−0.006	18.406
	(−0.484)	(1.161)
Cash Holdings	−0.008	−0.939
	(−1.160)	(−0.180)
Dividend Payouts	0.066	−12.742
	(1.244)	(−0.467)
Asset Tangibility	−0.004	−3.257
	(−0.412)	(−0.813)
Discretionary Spending	−0.010	−7.067
	(−0.583)	(−0.814)
ESG Score	−0.000	−0.108***
	(−0.207)	(−2.969)
Staggered Boards	0.007**	1.552
	(2.299)	(0.988)
Share Repurchases	0.003	−5.709
	(0.345)	(−0.806)
Constant	0.126***
	(3.341)
Firm Fixed Effects	Yes	Yes
Year Fixed Effects	Yes	Yes
Observations	6,066	6,066
Adjusted R-squared	0.960	0.343
Cragg-Donald Wald F statistic	1696.05***

Robust t-statistics in parentheses.

*** p < 0.01, ** p < 0.05, * p < 0.1.

The ESG controversies score is provided by Refinitiv. A high value of the score indicates fewer ESG controversies, relative to the industry peers. The hostile takeover index is constructed by Cain, McKeon, and Solomon (2017) primarily based on the staggered adoption of state legislations. A higher value of the takeover index suggests higher takeover vulnerability. The ESG score is also provided by Refinitiv. A higher value indicates more ESG activities.

Table A3. Regression analysis with additional control variables.

	(1)
	ESG Controversies Score
Hostile Takeover Index	16.174**
	(2.354)
Firm-specific Characteristics
Firm Size	−9.613***
	(−7.461)
Leverage	8.854
	(1.605)
Profitability	18.629*
	(1.928)
Capital Investments	28.451
	(1.649)
Advertising Intensity	−63.617*
	(−1.980)
R&D Intensity	−2.324
	(−0.161)
Cash Holdings	−16.747***
	(−3.147)
Dividend Payouts	−21.160
	(−0.771)
Asset Tangibility	−5.643**
	(−2.203)
Discretionary Spending	−7.184
	(−1.184)
ESG Score	−0.193**
	(−2.940)
Board Characteristics
Ln (Board Size)	7.954*
	(1.872)
Board Independence (% Independent Directors)	−0.035
	(−0.706)
Board Gender Diversity (% Female Directors)	0.059
	(0.798)
Board Ethnic Diversity (% Ethnic Minority Directors)	−0.036
	(−0.848)
Institutional Ownership
Institutional Ownership (%)	14.433***
	(4.721)
Industry-level Variables
Herfindahl Index (Market Competition)	−4.918
	(−1.398)
Industry Leverage	−9.220
	(−1.175)
Industry Profitability	−33.570*
	(−1.811)
Constant	153.005***
	(12.982)
Year Fixed Effects	Yes
Observations	4,139
Adjusted R-squared	0.237

Robust t-statistics in parentheses.

*** p < 0.01, ** p < 0.05, * p < 0.1.

The ESG controversies score is provided by Refinitiv. A high value of the score indicates fewer ESG controversies, relative to the industry peers. The hostile takeover index is constructed by Cain, McKewon, and Solomon (2017) primarily based on the staggered adoption of state legislations. A higher value of the takeover index suggests higher takeover vulnerability. The ESG score is also provided by Refinitiv. A higher value indicates more ESG activities.