Corporate goodness and shareholder wealth

Abstract

Using a unique data set, I study how stock markets react to positive and negative events concerned with a firm׳s corporate social responsibility (CSR). I show that investors respond strongly negatively to negative events and weakly negatively to positive events. I then show that investors do value “offsetting CSR,” that is positive CSR news concerning firms with a history of poor stakeholder relations. In contrast, investors respond negatively to positive CSR news which is more likely to result from agency problems. Finally, I provide evidence that CSR news with stronger legal and economic information content generates a more pronounced investor reaction.

Introduction

Economic theory suggests that companies should not internalize the negative externalities they exert on nonshareholding stakeholders such as communities, employees, or the environment (see, e.g., Pigou, 1920). Similarly, Friedman (1970) declared in his well known New York Times essay that the sole “social responsibility of business is to increase its profits.” Nevertheless, companies continue to channel significant resources to improving their relations with key stakeholders. Although putting an accurate figure on exactly how much large corporations spend on corporate social responsibility (CSR) initiatives is difficult, Hong, Kubik, and Scheinkman (2012) quote anecdotal evidence showing that annual CSR outlays of large U.S. corporations can and do end up in the hundreds of millions of dollars.

At the same time, an impressive body of research has been devoted to understanding whether and how investments in stakeholder relations impact a firm׳s profitability. Yet, much of this research has yielded inconclusive results: some studies find a positive relation, whereas others show a negative or no relation at all. Margolis, Elfenbein, and Walsh (2007) conduct a meta-analysis of many such empirical studies and conclude that the average relation between CSR and profitability is positive but small. In the present paper, I revisit the salient question of whether and how CSR matters for shareholder value by analyzing how investors react to positive and negative CSR events¹ in the short-run.

Some have argued that CSR is simply the manifestation of agency problems inside the firm (see Tirole, 2001, Bénabou and Tirole, 2010; Cheng, Hong, and Shue, 2013). According to this line of thought, CSR primarily benefits managers who, at the expense of shareholders, earn a good reputation among key stakeholders (e.g., local politicians, non-governmental organizations, or labor unions). Consequently, this agency perspective implies that positive news about CSR is bad news for shareholders. In contrast, an alternative perspective holds that companies engage with stakeholders for value-enhancing purposes. This view is sometimes referred to as “doing well by doing good,” and Edmans (2011), Dimson, Karakas, and Li (2013), Derwall, Guenster, Bauer, and Koedijk (2005), Flammer (2013a), Servaes and Tamayo (2013), or Dowell, Hart, and Yeung (2000) provide examples of mechanisms through which CSR can enhance shareholder wealth. Under this value-enhancing view of CSR, managers engage with stakeholders simply because such projects are deemed to have positive net present value (NPV), and thus, positive news about CSR should be received favorably by shareholders. In this paper, I disentangle the short-run shareholder value implications of such agency and value-motivated CSR and provide evidence consistent with the view that when CSR is more likely to be driven by agency problems, it is detrimental to shareholder value. In contrast, shareholders tend to react positively to CSR news whenever it is more likely to be the result of the firm addressing problematic stakeholder relations by “offsetting” previous corporate social irresponsibility.²

The second contribution of this paper is to provide unique short-run event study evidence on the shareholder value implications of CSR data by Kinder, Lydenberg, and Domini Research and Analytics (KLD), a data provider whose measures are widely used in the financial economics literature (see, e.g., Statman and Glushkov, 2009; Gillan, Hartzell, Koch, and Starks, 2010; Hong and Kostovetsky, 2012; Hong, Kubik, and Scheinkman, 2012; Cheng, Hong, and Shue, 2013; Di Giuli and Kostovetsky, 2014; Albuquerque, Durnev, and Koskinen, 2013; Servaes and Tamayo, 2013; Deng, Kang, and Sin Low, 2013).³ Thirdly, this paper provides thought-provoking and novel insights into the measurement and value implications of CSR by relying on textual analysis in the spirit of Tetlock (2007): I show, for instance, that investors react more strongly to CSR news containing strong economic and legal information content. Finally, the present paper is innovative because it explicitly addresses two methodological concerns that are pervasive in research concerned with CSR, namely, (i) measurement error and (ii) reverse causality.

Measurement error is an issue in research that examines the value implications of CSR because of the difficulty in accurately quantifying CSR given the qualitative nature of many CSR-related issues. In addition, no legally binding standards exist that require publicly listed companies to report coherently and, above all, truthfully on the extent to which they impose positive or negative externalities on their stakeholders. Although numerous private and non-private sector reporting and certification initiatives exist,⁴ regulators such as the Securities and Exchange Commission (SEC) have only tentatively started to explore the notion of making the disclosure of environmental and social information a mandatory listing requirement for public firms.⁵ Another reason why accurately measuring a firm׳s stakeholder relations remains difficult is that overall measures of the effects of corporate actions on the welfare of stakeholders do not exist. For example, corporate policies that benefit communities might turn out to be harmful to employees. Hence, coming up with a measure of overall stakeholder value is particularly challenging (see Tirole, 2001). Finally, outsiders (e.g., investors or regulators) cannot observe firm choices regarding CSR, implying that measures are likely to be biased, because firms have an incentive to greenwash, i.e., overstate their good and understate their bad deeds.

To overcome these measurement challenges, this paper focuses on outcomes of corporate behavior in the form of publicly observable events. I do so by constructing a unique data set of 2,116 corporate events with either positive or negative implications for the wellbeing of a firm׳s main stakeholders (e.g., communities, customers, the environment, or employees). In contrast to prior research, which focuses strongly on analyzing largely time-invariant CSR ratings,⁶ the event-related data in the present study are of point-in-time nature. Focusing on publicly observable events is akin to studying changes in shareholder value at instances during which investors update their beliefs about a firm׳s stakeholder relations. Using such high-frequency point-in-time CSR measures allows for the precise measurement of both the date and information content of the events, enabling me to credibly address the measurement error problem.

Relying on short-run event study methodology allows for the effective handling of the second problem in research concerned with the value implications of CSR, i.e., the omnipresent reverse causality issue: studies that regress portfolio returns of trading strategies or other annual measures of firm value (e.g., Tobin׳s q) on low-frequency measures of CSR (e.g., annual ratings) cannot address the basic question of whether companies do well because they do good or whether they do good because they do well. Hence, the mere observation of a positive correlation between some low-frequency CSR measure and value is consistent with at least two different interpretations: either more responsible firms tend to be more profitable or, alternatively, more profitable firms tend to channel more resources into projects that increase the wellbeing of stakeholders. In fact, Hong, Kubik, and Scheinkman (2012) provide causal evidence that less financially constrained firms tend to have better CSR performance, which is somewhat consistent with the latter view.

Because this paper examines short-run changes in shareholder value in response to high-frequency changes in CSR, I can plausibly mitigate these reverse causality concerns. This is because the short-run stock market reaction gives a direct estimate of the NPV associated with an event, and the precise knowledge of the timing as well as the information contained in an event allows discarding alternative explanations for changes in shareholder value. On the contrary, research relating long-run returns or annual measures of valuation or profitability to low-frequency (e.g., annual) measures of CSR cannot credibly rule out that a positive relation between CSR and profitability is in fact driven by a latent factor, which is correlated with both the firm׳s profitability and its commitment to CSR. Finally, long-run studies are also sensitive to the presence of confounding effects because, after all, a plethora of value-relevant events which are not necessarily related to CSR occur throughout a year.

I show that investors react strongly negatively to the arrival of negative CSR news. The negative reaction is particularly pronounced for information regarding communities and the environment. Declining stock prices following the release of negative stakeholder information is consistent with the view that there is a substantial and non-negligible cost associated with social irresponsibility. The median cost of negative CSR, which I calculate as the product of the median sample market capitalization and the median 21-day cumulative abnormal return (CAR), is approximately $76 million. Although such a negative stock market reaction is a necessary condition for CSR to be in the shareholder׳s best interest, it does not yield a sufficient condition. This is because negative shareholder wealth effects with respect to negative events provide no insights into the costs associated with implementing policies aimed at reducing the likelihood of negative events.

Turning to the analysis of positive events, this paper provides evidence that investors respond slightly negatively to the release of positive CSR news. Again, the reaction is most pronounced when the news concerns communities or the environment. However, the negative reaction with respect to positive information is much weaker, both economically and statistically. The weakly negative reaction to positive news regarding CSR suggests that, unconditionally, investors do not appreciate the implementation of CSR policies. Focusing on the average stock market reaction with respect to positive events might be disguising, however, that CSR-related policies could enhance shareholder value under certain circumstances. As previously outlined, it could be that dependent on certain conditions (e.g., the desire to improve poor environmental policies or to make a notoriously dangerous workplace safer by investing in health and safety measures), CSR projects may actually have positive NPV. To explore this idea of conditionality, I separate positive events according to whether they are more likely to be the result of agency problems or the firm׳s desire to offset previous episodes of corporate social irresponsibility.

First, I measure agency problems in the spirit of Jensen (1986) by focusing on book leverage and liquidity. High leverage constrains managers to spend corporate resources sensibly, whereas high liquidity provides greater scope for wasteful spending through negative NPV projects. Hence, high leverage and low liquidity should indicate fewer agency concerns, and positive CSR events involving such firms should bring about more positive stock market reactions. Second, I build on a recent paper by Kotchen and Moon (2012) showing that firms that do more harm to stakeholders tend to “offset” such corporate social irresponsibility by improving their stakeholder policies in the future. In line with this view, I argue that the extent to which companies face problems with their stakeholders at the occurrence of an event is a reasonable proxy for whether the positive CSR event is more likely to be the result of value- or agency-motivated corporate policies. As such, positive events concerning firms with poor stakeholder relations should be received more positively by shareholders than events concerning firms with no apparent controversies.

The analysis largely confirms the view that the value implications of positive CSR events do depend on the motivation for stakeholder engagement. First, positive events concerning high-leverage and low-liquidity firms turn out to generate significantly higher cumulative abnormal returns (CARs). Likewise, and in line with the idea that offsetting CSR in the spirit of Kotchen and Moon (2012) has different shareholder value implications, positive events regarding companies with known controversies generate a significantly more positive stock market reaction than positive events concerning firms with no apparent stakeholder problems. Taken together, the results from analyzing the cross section of CARs provide an economic justification, and thus a sufficient condition for companies with bad stakeholder relations to improve their CSR policies.

The remainder of the paper is organized as follows. The next section provides an overview of the related literature. Section 3 introduces the sources of the data. Section 4 presents the baseline event study results. In Section 5, I present the results from examining the value implications of agency-motivated and offsetting CSR. In Section 6, I examine the textual characteristics of the events and relate CARs to the textual variables before concluding in Section 7.