Finance & Investing

How Corporate “Diversity Washers” Spin Investors

More companies are playing up their DEI efforts — without improving their records on racial and gender diversity.

August 21, 2024

| by Seb Murray

Vague disclosures about diversity can be a distraction from actual workplace demographics. | istock/Yau Ming Low/Sarah McKinney

In 2023, shareholders sued Wells Fargo, alleging that the bank had conducted “sham” job interviews so it could claim that at least half of the candidates interviewed for high-paying jobs came from “diverse” backgrounds. That case was dismissed, but a new class action suit has picked up the complaint, arguing that the company misled investors with exaggerated diversity stats.

These claims highlight “diversity washing,” the practice of publicly overhyping or misrepresenting diversity initiatives to gloss over actual diversity data. It has become more common as corporate America has emphasized its commitment to diversity, equity, and inclusion (DEI) and efforts to increase racial and gender diversity in its workforce.

Beyond its PR value, diversity washing appears to pay off. In a recent paper in the Journal of Accounting Research, David Larcker, an emeritus professor of accounting at Stanford Graduate School of Business and distinguished visiting fellow at the Hoover Institution, and Edward Watts, PhD ’20, of the Yale School of Management, find that “diversity washers” often receive higher environmental, social, and governance (ESG) ratings and attract investment from socially responsible funds despite their poor performance on DEI measures.

“This misalignment between what is reported and what is practiced can mislead investors and stakeholders, causing the misallocation of capital,” Larcker says.

Despite accusations such as those leveled at Wells Fargo, there has been limited data on the scale of diversity washing, Larcker and Watts note in their paper, coauthored with Andrew Baker, PhD ’21, of University of California, Berkeley, law school Charles McClure, PhD ’18, of the Booth School of Business at the University of Chicago; and independent scholar Durgesh Saraph, PhD ’15. Yet their research suggests that many firms are paying lip service to DEI goals.

By counting DEI-related terms in companies’ financial documents, the researchers found that discussions about diversity have become more frequent since 2020, even as racial and gender diversity in their workforces has not changed much. Companies with greater diversity do talk about DEI more often, but this link is weak, suggesting that many businesses are using “opportunistic DEI disclosures” to overplay their commitment to diversity.

Diversity and Diversion

The researchers confirmed their results by showing that companies identified as diversity washers perform poorly on DEI-related outcomes. They are more likely to face Equal Employment Opportunity Commission penalties for discrimination-related violations and negative news about their workforce.“These large disconnects between what companies say and do on diversity are predictive of very negative behaviors,” Watts says. “If you have a bigger disconnect, you’re more likely to have a questionable diversity policy without a hard target.”

Quote
These large disconnects between what companies say and do on diversity are predictive of very negative behaviors.
Attribution
Edward Watts

The results indicate that companies identified as diversity washers often extend their misleading behaviors beyond financial disclosures; their emphasis on DEI extends to other communication platforms like corporate social responsibility reports and social media.

Moreover, the researchers found that these companies hire fewer diverse candidates, even among junior employees. Such firms often use forward-looking language about DEI, the researchers say, suggesting that they are not aiming to increase diversity but rather trying to distract from their current shortcomings.

However, the researchers find that these misleading disclosures have a positive effect on how investors view the companies’ ESG performance. Using data from two major ESG rating providers, Refinitiv and Sustainalytics (which rely on voluntary company disclosures), the study found that diversity washers receive higher overall ESG scores and are more likely to be owned by ESG-focused mutual funds.

This indicates that investors may focus more on what companies say about DEI rather than their actual demographics. “Are investors being tricked?” Watts asks. He notes this has important implications for financial markets because other studies have found that ESG ratings can be inconsistent and unclear.

This could explain why companies may choose to misrepresent their commitment to DEI: according to some surveys, ESG-focused investors are expected to control a third of all institutional assets by 2025. Also, DEI audits are rare and receive minimal shareholder support, and most lawsuits against firms for failing to uphold DEI commitments have been dismissed by the courts — as happened in the initial Wells Fargo case.

Larcker, Watts, and their coauthors found that diversity washers tend to use vague and ambiguous language when talking about DEI. This lack of clarity may help them avoid successful shareholder lawsuits, they wrote, as less precise disclosures can reduce litigation risk.

Overall, this misrepresentation means that socially responsible investments may not go to the right companies. While the Securities and Exchange Commission has focused on false marketing by investment funds, the study highlights the need for stricter enforcement of ESG claims by companies themselves.

The research also points to the importance of standardized, mandatory disclosure requirements for ESG issues to ensure truthful reporting by firms. “There have been growing pressures for disclosures related to diversity and pushback from companies, but without this information, investors cannot make educated decisions,” Watts concludes.

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