The Inside Information Regime of the MAR and the Rise of the ESG Era

In our recent paper, we explore the potential impact of ESG-related information and of the increase in ESG-compliant investments on the prohibition on insider dealing and the obligation to publicly disclose inside information. Environmental, social and governance-compliant investing (‘ESG investing’) has emerged as a major social topic in recent years. The rise in ESG investing has been characterized as an ‘investor revolution’ and a manifestation of social change. We believe that the ESG preferences of a critical mass of real-life investors and, as a corollary, ESG-related information are, and will continue to be, of great importance to the inside information regime of the Market Abuse Regulation (‘MAR’).

The impact of ESG-related information on the development of share prices:

At the outset, one must distinguish between (i) the question of whether ESG factors are relevant to the fundamental value of shares, thus affecting their pricing on the basis of neo-classical capital market theory and (ii) the question of whether a substantial shift in investor preferences is to be expected, which will impact share prices by way of rising demand even in the absence of any relevance of the ESG factors to fundamental value. In particular:

(i) In capital market theory, the fundamental value of a financial instrument is dependent on future cash flows and the risk associated with that financial instrument. It is determined by discounting all future cash flows, ie by determining the present value of the financial instrument (discounted cash flow method). ESG factors may, within the framework of these neo-classical assumptions, affect share prices only where they affect either future cash flows or the discount factor. For example, it is conceivable, and the subject of extensive debate within the scientific community, that ESG factors could affect the discount rate by influencing the cost of capital, due to the operation of the so-called systemic risk transmission channel. One argument in this regard contends that a positive ESG profile should make companies less susceptible to systematic market shocks, thereby exposing them to a lower level of systematic risk.

(ii) Moreover, significantly changing investor preferences could play a major role in shaping the impact of ESG factors on share prices in the future. Were a sufficiently large number of investors to cease to exclusively pursue the goal of maximizing financial returns and instead take ESG factors into account, assigning them equal weighting or even priority when making investment decisions, the resultant share prices would systematically deviate from the assumptions adopted in accordance with common capital market equilibrium models. A rise in demand for financial instruments from issuers with a positive ESG profile would lead to a higher market price for the securities in question—irrespective of the impact of ESG factors on future cash flows or the discount factor. Conversely, companies with a negative ESG profile will face increasing equity costs, which in turn will lead to a decline in their enterprise value.

Despite these theoretically plausible implications, no consensus or unambiguous empirical evidence has yet emerged with regard to the existence of any correlation between ESG factors and stock market performance.

What are the implications of these observations for the inside information regime of the MAR?

In identifying whether, and if so when, ESG-related information may constitute inside information within the meaning of Article 7(1) of the MAR, the potential impact of information on the price of the financial instrument in question is decisive, and must be assessed from the ex ante perspective of a ‘reasonable investor’.

Divergent conceptions of the ‘reasonable investor’:

National competent authorities, legal literature and national courts have thus far defined the concept of the ‘reasonable investor’ quite differently. To date, there has been some disagreement, in particular, as to whether and to what extent the ‘reasonable investor’ should take irrational investor behaviour into account. 

• Some commentators argue that the ‘reasonable investor’ is an average individual or entity interested in maximizing its financial returns and behaving in a rational way. Such an investor will take predictable (irrational) behaviour of other market participants into account where it is of value from a financial perspective.
• In contrast, other commentators have put forward valid arguments as to why the ‘reasonable investor’ should not have regard to any such irrational market behaviour. Some of the proponents of the view denying the relevance of irrational investor behaviour define the reasonable investor as the embodiment of the efficient capital market hypothesis (ECMH), and therefore tend to advocate in favour of taking into account only information that relates to the economic opportunities and risks associated with the financial instrument in question and thus to the fundamental value of the issuer’s securities.

Non-financial investor preferences and the inside information regime:

To the extent that the shift in the preferences of a critical mass of real-life investors towards non-financial considerations leads to a predictable reaction of prices to ESG-related information, without the degree of such sensitivity being justified by the impact of the underlying circumstances on the fundamental value of the financial instrument, there are significant differences between the different approaches. Indeed, commonly used theories and models, including the ECMH and the Capital Asset Pricing Model (‘CAPM’), proceed on the assumption that rational investors take only fundamental value-related information into account. Such idealized model investors would not change their investment behaviour on the basis of ESG-related information which had no impact on the fundamental value of the financial instrument in question.

Therefore, from a legal point of view, the crucial question is whether the MAR implicitly prescribes the adoption of certain model assumptions, in particular the assumptions on which the ECMH is based, and thus predetermines the outcome in a manner which is binding on the legal practitioner, the supervisory authorities and the courts. Were this the case, investor preferences of a non-financial nature would not be of any relevance to the prohibition on insider dealing and the obligation to publicly disclose inside information, and ESG-related information would necessarily be relevant only where it affects future cash flows or the discount factor.

In our paper (see section B.IV), we demonstrate that the arguments in favour of the irrelevance of irrational investor behaviour scarcely touch on the issue of whether the shift in investor preferences to include non-financial considerations may be of significance for the prohibition on insider dealing and the obligation to publicly disclose inside information. Furthermore, it is in our opinion rather doubtful that the MAR subscribes to any particular economic theory (ECMH) or its underlying assumptions.

In light of the above, we are strongly inclined to acknowledge the relevance of ESG preferences of a critical mass of real-life investors to the inside information regime. However, the intense debate regarding the precise depiction of the ‘reasonable investor’ indicates that the relevance of ESG-related information to the MAR regime is by no means clear. Given these uncertainties and its efforts to promote sustainable finance, the EU would be well advised to further specify the concept of the ‘reasonable investor’ and/or the concept of inside information, with a particular focus on ESG-related information.

Peter O. Mülbert is Professor of Law at the University of Mainz, Germany.

Alexander Sajnovits is Post-Doctoral Research Fellow at the University of Mainz, Germany.