“Auto makers recalled a record 51.26 million vehicles in the U.S. in 2015, continuing a historic surge for car companies facing an unprecedented government crackdown on safety lapses,” reported Mike Spector for the Wall Street Journal.  “The total topped the 50.99 million vehicles recalled in 2014, regulators said Thursday.”

These recalls, which have in some cases been accompanied by cover-ups, have had sizeable financial consequences for some automakers—last fall, Porsche SE (Volkswagen’s parent company) reported a massive drop in their nine-month profits. While recalls aren’t ever good news, a 2009 paper in the Journal of Marketing by Yubo Chen, Shankar Ganesan, and Yong Liu had some surprising lessons for companies faced with the problem.

They analyzed 12 years of data on Consumer Product Safety Commission recalls to compare the effects of two different types of responses to product recalls. “At one extreme, firms forsake (or try to forsake) any responsibility for the defective product by denying culpability and delaying the recall process,” they wrote. “At the other extreme, firms respond to consumer complaints early, issue speedy voluntary recalls, communicate extensively with consumers and other stakeholders, and often provide additional compensation beyond the legal requirement.”

How Companies Should Handle Recalls

The conventional wisdom suggests that the latter option—the proactive one—is the optimal strategy.  Customers, so the thinking goes, appreciate honesty and transparency, will be more willing to forgive and continue to patronize, a company that didn’t cover up its missteps. Chen, Ganesan, and Liu’s research, however, suggested the opposite: customers may prefer a proactive approach, but investors don’t. Companies that respond proactively are punished more by the market than companies that utilize a more passive approach.

What explains this puzzle?  It may be that proactive recall strategies send a message to investors that the situation may be truly dire:

Our findings indicate that investors may view proactive recall strategies differently from consumers, interpreting them as a signal of severe product hazard and financial damage (i.e., the expenses related to the recall process, potential litigation, liability, and penalty payment for damages to consumers or properties are substantial) to the firm.

The authors are careful to point out that their research doesn’t necessarily mean firms shouldn’t manage product recalls responsibly and proactively. They simply suggest that firms should be aware of how their actions might be perceived by both customers and investors.

“In terms of financial value, the stock market’s pessimistic views of a proactive strategy could actually hurt firm value,” the researchers concluded. “As a result, when a firm proactively recalls a product, it needs to communicate effectively to the stakeholders about the rationale for its actions so that the stock market will not simply interpret the situation as just another case of severe product hazard and significant financial losses. “