EXECUTIVE DIGEST

Corporate social responsibility, corporategovernance, and financial performance:Lessons from finance

Robert Neal, Philip L. Cochran *

Kelley School of Business, Indiana University, 801 West Michigan Street, Indianapolis, IN 46202-5151, U.S.A.

Business Horizons (2008) 51, 535—540

www.elsevier.com/locate/bushor

1. Just how influential is corporatesocial responsibility?

What can management and, in particular, businessethics learn from recent research in finance? One ofthe problems with much of modern scholarship isthat there is often little communication betweenvarious ‘‘academic silos.’’ The authors of this articlehave reviewed a range of recent studies published inthe finance field. These studies suggest that firmspracticing good ethics and good corporate gover-nance are rewarded by the financial markets, whilefirms practicing poor ethics and poor corporategovernance are punished.

Corporate social responsibility (CSR) looks at howfirms treat their stakeholders. One key stakeholdergroup that is frequently overlooked is the firm’sshareholders. All too often, the corporate socialresponsibility literature focuses on customers, em-ployees, and the natural environment, but rarely onshareholders. The focus of this article is the impactof the firm on its shareholders as expressed throughits corporate governance practices. If a firm can’ttreat its shareholders well, what hope is there forthe other stakeholders? Herein, we argue that thereare market forces at work which reinforce good CSR

* Corresponding author.E-mail addresses: skyking@iupui.edu (R. Neal),

plcochra@iupui.edu (P.L. Cochran).

0007-6813/$ — see front matter # 2008 Kelley School of Business, Idoi:10.1016/j.bushor.2008.07.002

behavior. A natural starting point is to examine thelessons from one of the most prominent bankrupt-cies in U.S. history.

1.1. Lessons from Enron

In addition to being the largest bankruptcy in Amer-ican corporate history, Enron is also a prime exampleof corporate social irresponsibility. In particular,Enron provides one of America’s most striking ex-amples of stakeholder neglect. From 1998 to the endof 1999, Enron had been one of the stars of thefinancial markets. It was innovative and aggressive.It had an apparently well-structured business modeland seemed to be very profitable. Then, in the spaceof a year, it all collapsed. The firm went from havingamarket capitalization of over $60 billion in January2001, to bankruptcy less than 12 months later (seeAppendix).

How could this happen? Enron was founded in1985 from the merger of two natural gas pipelinecompanies. At that time, the U.S. energy marketwas changing from regulated prices and low naturalgas production to deregulated prices and dramat-ically expanded production. Themarket shifted fromlong-term fixed price contracts, to transactionsbased on the current spot market price. Both devel-opments made Enron’s pipelines more valuable.

The prices in the new spot markets, however,were more volatile and many natural gas customers

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were conservative utilities. Enron realized that itcould position itself as an intermediary in the natu-ral gas business. By absorbing much of the price risk,Enron could offer its customers long-term fixedprice contracts that could help them manage theprice risk of natural gas. This business model provedto be highly profitable; by the mid-1990s, Enron wasaccruing greater profits from its operations as a riskmanager than from its pipeline operation.

At about this same time, several other changesoccurred. First, to maintain the company’s growthrate, Enron expanded into areas that were notclosely related to its area of expertise as energyintermediaries. Enron designed and built powerplants overseas, acquired paper and pulp factories,and purchased water utilities. While the existenceof a diversification discount has been the subject ofmuch research, recent findings (Mackey & Barney,2005) have tended to support the original conclusionthat unrelated acquisitions can reduce firm value.

Second, Enron’s ‘‘off-balance-sheet’’ entriesgrew rapidly. Most of these entries were ‘‘derivativecontracts’’ that were structured to offset the ex-posures that Enron faced from offering long-termnatural gas contracts. Thus, Enron could reduce itsexposure to future price volatility by locking in bothcosts and income.

At this point, it would be useful to describe thedifference between on-balance-sheet and off-bal-ance-sheet items in U.S. financial statements. Formany years, U.S. accounting required that only ‘‘tan-gible’’ items be represented on the balance sheet–—things such as physical plants and accounts due to bepaid soon. Since the ultimate payoff of derivativecontracts is difficult to predict, these contracts wererelegated to the off-balance-sheet entries. As thenumber of off-balance-sheet entries grew, financialtransparency suffered. It became increasingly moredifficult to understand a firm’s economic exposure tosuch entries. Fortunately, recent accounting rulechanges have improved the situation and made thefinancial statements more informative.

Returning to Enron, the third development wasadoption of accounting practices that ranged fromvery aggressive to clearly illegal. In one case, Enroncreated an off-balance-sheet company, whose prof-its were double-counted for both the company andEnron itself. When subsequent changes should haverequired Enron to consolidate the balance sheets, itviolated the accounting rules and chose to keep thecompany off its balance sheet. When this problemwas finally rectified, Enron was required to take a$1.4 billion write down.

These developments–—especially the accountingfraud–—made it possible for Enron to disguise its truecondition from investors. Arthur Andersen, the

firm’s auditor, was heavily involved in consultingactivities with Enron. Many have argued that theselucrative consulting contracts created a conflict ofinterest, and led Andersen to ignore the warningsigns in Enron’s financial statements. Andersenclearly failed in its auditing role. In addition, Enron’sexpansion into areas outside its expertise eventuallyproduced losses for the company, and fraudulentaccounting pumped up the profits of the energytrading business. It was a bubble waiting to burst.

The lessons of Enron, however, go far beyondfraud and bankruptcy. It has forced us to ask: Howcould this happen? What were the auditors doing?How could they have missed Enron’s true activities?What about the bankers who lent money to Enron?Didn’t they examine the financial statements care-fully? What about professional investors like mutualfunds and pension funds? What about the agenciesthat rated Enron’s bonds? Not only do all theseparties have a vested interest in correct financialanalysis, they also have fiduciary and legal obliga-tions to get the analysis right. The parties areregulated by a variety of sources, including theU.S. Securities and Exchange Commission (SEC),the U.S. Federal Reserve Bank, the U.S. Departmentof Labor, the Financial Accounting Standards Board,and the New York Stock Exchange. In the words ofHealy and Palepu (2003, p. 4):

Despite this elaborate corporate governance andintermediation network, Enron was able to at-tract large sums of capital to fund a questionablebusiness model, conceal its true performancethrough a series of accounting and financing ma-neuvers, and hype its stock to unsustainable lev-els. We believe that the problems of governanceand incentives that emerged at Enron can alsosurface at many other firms, and may potentiallyaffect the entire capital market.

2. An answer? The Sarbanes-Oxley Actof 2002

One reaction to the problems of Enron was theSarbanes-Oxley Act. This law was adopted in 2002as a response to growing frustration with corporategovernance and the lack of transparency of financialstatements among U.S. firms. The concerns werehighlighted by the massive run-up and collapse oftechnology company stock prices and by the largestbankruptcies in U.S. corporate history. For example,the NASDAQ Composite Stock Index rose 180% fromMarch 1998 to its peak in March 2000. Only 2 yearslater, all those gains had evaporated. In 2001 and2002, 446 publicly traded firms with assets of $628billion went bankrupt.

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The changes from the Sarbanes-Oxley Act fallprimarily into three areas: auditing, financial re-porting, and corporate governance (see Appendix).In the auditing area, the primary change was thecreation of the Public Company Accounting Over-sight Board, a regulatory organization designed todevelop and enforce auditing standards. Otherchanges included strengthening the independenceand authority of firms’ audit committees, disclosureof auditing fees and relationships, and limiting theability of auditing firms to provide both auditing andconsulting services to the same company.

Under Sarbanes-Oxley, Chief Executive Officersand Chief Financial Officers are now required topersonally certify the accuracy of the firm’s financialreports, and the SEC must review the statementsevery 3 years. The Act requires increased disclosureof off-balance-sheet items and contractual obliga-tions, transactions betweenmanagement and princi-ple stockholders, and real-timedisclosureofmaterialchanges in operating or financial condition.

In the corporate governance area, firms mustdevelop and disclose corporate codes of ethics,and assess the effectiveness of internal audit andrisk management controls. CEOs and CFOs may berequired to forfeit compensation if the firm has torestate its financial statements, and senior manage-ment faces additional criminal and civil penaltiesfor defrauding shareholders.

3. Necessary changes? In the light offinance

Were the changes introduced by Sarbanes-Oxleyreally necessary? Or were they an over-reactionto current events? Methodology used in Financecan address these questions from the perspectiveof at least one stakeholder group, namely stock-holders, by looking at the stock price reaction toadoption of the new law. If a company’s stock pricedeclines, then either the additional disclosure isnot valued by investors or they consider it notworth the incremental costs. In either case, thecosts of compliance reduce firm profits. If the stockprice rises, however, then the additional disclosureis valued by investors and the increased transpar-ency makes them more willing to purchase addi-tional shares.

With this in mind, the authors examined recentstudies published in Finance journals to determinewhat light they might be able to shine on thisquestion. A recent analysis by Jain and Rezaee(2006) examined these two alternatives. In theU.S., changes in law require a legislative processthat usually takes years. The Sarbanes-Oxley Act,

however, was enacted very quickly, and so repre-sents a significant unanticipated event to the finan-cial markets. Jain and Rezaee examined theperformance of stock indices on days when politicaldevelopments increased the likelihood that the Actwould be approved, and on days when the likelihoodfell. They found that stock prices tended to risewhen the likelihood increased, and fell when thelikelihood decreased. Thus, the stock market re-acted favorably to news of the additional disclosureand transparency requirements.

Consistent with this finding, Jain and Rezaee con-ducteda secondtestwhereby theyused transparencyand disclosure indices to measure the quality of afirm’s corporate governance. They found that firmswith good governance had a positive price reaction tothe new disclosure and transparency requirements,while those with poor governance had a negativereaction. Overall, the results suggest that good cor-porate governance is valued in the stock market andthat investors are willing to pay more for a companywith good governance principles.

Another recent study indicated that good corpo-rate governance is valued in the financial markets.Gompers, Ishii, and Metrick (2003) constructed ameasure of the quality of corporate governance andrelate the firm’s governance to its profitability,operating performance, and stock returns. Theirgovernance measures are based on the ability ofshareholders to monitor and control a firm’s man-agement. Corporate policies that limit these abili-ties, such as poison pills to prevent hostiletakeovers, and staggered boards that make it diffi-cult to change a firm’s board of directors will give afirm a lower score in their quality index.

Gompers and colleagues’ study examines 1,500U.S. companies from 1990 to 1998. For each firm,they construct an aggregate measure of corporategovernance based on 24 variables. Their results arequite striking. The firms that were classified ashaving very poor governance underperformed themarket by 3.5% per year, while firms that wereclassified as very good outperformed the marketby 5% per year. Thus, the difference between goodand bad corporate governance in the U.S. is about8.5% per year.

These same authors find similar, but statisticallyless robust, results for other performancemeasures.Over the 1991 to 1999 period, firms that practicedgood governance reported higher average profitmargins, higher average sales growth, and higheraverage return on equity (ROE). Overall, the infer-ence drawn from these results is that poor gover-nance tends to produce poor firm performance.Likewise, good governance tends to produce goodperformance.

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Yermack (2006) provides yet another perspectiveon how corporate governance is valued in the equitymarkets. He argues that agency problems–—conflictsof interest between the firm’s shareholders and thefirm’s management–—are one of the most importantgovernance challenges and reflect the quality ofcorporate governance. Yermack proposes a novelway of measuring the degree of agency problemsby looking at the perks enjoyed by topmanagement.While perks can be used as incentives to motivatemanagers, they can also reduce firm value if theyare used too intensively.

Yermack’s study focuses on the personal use ofcompanyaircraft byCEOs. In oneextremeexample, afirm provided senior management with 10 aircraftand 36 full-time pilots. The planes were frequentlyused by celebrities, golf instructors, family friends,and even pets. From 1993 to 2002, he finds thatreported aircraft use tripled, a fact he attributesto both increased use and stronger SEC disclosurerequirements.

Yermack finds that the disclosure of personalaircraft use is associated with about a 1% initialdecline in firm value and, over the next year, thefirm underperforms the market by about 4%. Consis-tent with the idea that personal aircraft use is anindicator of agency problems and a measure ofcorporate governance quality, he finds that firmswith aircraft aremore likely to report large account-ing write-offs. These firms are also more likely toreport earnings that are significantly below theforecasts made by analysts.

This pattern of the market reaction to corporategovernance also shows up in other countries, as well.For example, Giannetti and Simonov (2006) examinehow corporate governance influences investor own-ership in Sweden. Using data from 2001, they con-struct several measures of corporate governancebased on the likelihood that management will expro-priate wealth from shareholders. In their approach,total profits from a firm can either be distributed toshareholdersonapro-ratabasis or they canbeusedtodisproportionately benefit corporate insiders.

Giannetti and Simonov’s results show that thegovernance structure influences the pattern of eq-uity ownership. After controlling for factors like sizeor dividends that are likely to affect ownership, theyfind that investors who are more likely to be expro-priated–—small retail investors and foreign inves-tors–—hold smaller stakes in weak governancecompanies. Likewise, investors that are more likelyto receive the benefits of expropriation–—large do-mestic investors–—are more likely to hold largerstakes.

When the takeover process starts, the biddingfirm is willing to pay a price that is higher than the

current market price of the target company. Theratio of the offer price to the market price just priorto the takeover announcement is called the take-over premium. In cases where a large percentage ofthe firm was acquired, firms with poor governancestructures received a takeover premium of about 7%more than the good governance firms. Thus, even inSweden–—a country with high governance standardsand strict enforcement of securities laws–—expropri-ation risk significantly reduces the value of a firm.

Another illustration of governance problemsarises with the form of executive compensation.In the U.S., it is common for high-level executivesto receive stock options as part of their overallcompensation. The idea behind issuing these optionsis to align the interests of management and share-holders. According to this theory, if a significantportion of management’s wealth is the companystock, then the agency conflicts between sharehold-ers and management are reduced.

There is an important difference, however, be-tween granting stock options to executives andgranting them shares of the company. While bothfunction to reduce agency problems, the payoff ofthe stock is symmetric; the gain from a $10 increasein the stock price is the same as the loss from a $10decrease in price. In contrast, the payoff from astock option is asymmetric. Because the optionprice is a convex function of the stock price, thegain to the option from a $10 increase in the stockprice will exceed the loss from a $10 decrease.

Burns and Kedia (2006) show that firms in whichthe CEO’s compensation is more heavily tilted to-ward stock options are likely to employ aggressiveaccounting standards. These authors compare acontrol group of firms to firms which were requiredto restate their earnings because of GAAP violations.Burns and Kedia find a strong positive associationbetween the option delta and the likelihood ofearnings restatement. (Option delta is a term thatreflects the sensitivity of changes in the value of anoption to changes in the underlying stock price. Allelse constant, the higher the delta, the greater thevalue of an employee stock option.) In other words,the greater the sensitivity of a CEO’s stock optionsto the underlying stock price, the greater the likeli-hood of earnings manipulation.

The discussion of governance issues might createthe impression that the U.S. governance and ac-counting systems are fundamentally flawed. At leastrelative to the other industrialized countries, this isclearly not the case. A global survey of comparativeaccounting systems and standards by Lang (2003)argues that the U.S. standards–—despite all theirproblems–—offer investors the most protection.Comparisons between common law-based countries

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(U.S., UK, Australia, and Canada) and code-basedcountries (most of Western Europe) suggest thatcommon law systems provide outside investors amore transparent picture of corporate operations.

For example, Ball, Kothari, and Robin (2000) findthat countries whose legal systems are based onEnglish common law tend to exhibit a stronger corre-lation between reported earnings and stock pricereactions. This is interpreted as a measure of theinformativeness of accounting disclosure. The logic isthat if reported earnings are subject to manipulationby management, then investors will tend to discountthe reported earnings, and thus the correlation be-tween earnings and stock returns will be diminished.Among the common law countries, Ball and col-leagues find that U.S. firms exhibit the strongestcorrelation, suggesting U.S. standards are the mostinformative.

A similar conclusion is reached by Leuz, Nanda,and Wysocki (2003). These authors provide a com-parison of earnings management across 31 coun-tries. Their logic is that when companies smoothearnings over time, they provide a distorted pictureof the company’s financial condition. In particular,bad times are hidden from investors by ‘‘borrowing’’from future or past earnings. Leuz et al. examineseveral measures of earnings management and findthat U.S. firms tend to have the lowest levels ofearnings management, and thus the most informa-tive earnings statements. This, of course, does notmean that U.S. firms don’t manage their earnings; itonly means that U.S. firms have a lower degree ofmanaged earnings than firms in other countries.

Another type of comparison is provided in studiesthat examine firms which choose to cross list theirstock. Firms that list on a stock exchange are re-quired to meet the disclosure requirement of theexchange and the country; cross listing typicallyoccurs when emerging market firms seek listing onmore developed markets.

In a comparison of firms that choose to cross list inthe U.S., Miller (1999) finds that companies benefitfrom cross listing. On average, the value of the firmrises several percent from the dual listing. Theinference is that the greater disclosure requiredby the U.S. markets offers investors more transpar-ency and confidence in the reported financial state-ments. Cross listing thus offers firms the ability tocertify that their reports meet the high standards ofgood corporate governance, and thereby increasetheir attractiveness to investors.

Additional evidence comes from cross-sectionaltests. There are several differentways firms cancrosslist in the U.S., and these different ways have differ-ent disclosure requirements. Miller finds a positiverelation between the stock price reaction and the

degree of disclosure: firms that meet the stricterstandards tend to exhibit the largest price increase.

There are similar lessons in emergingmarkets. Thescope of the empirical studies is, however, muchmore limited. One interesting study examines theimpact of corporate governance among emergingmarket firms during the Asian Crisis of 1997-98.Mitton (2002) examines 398 firms across six differentcountries. He focuses on the potential expropriationof minority shareholders and argues that the crisisperiod increased the stress on companies, and madeexpropriation somewhat more likely. Accordingly,investors would avoid firms with poor governanceand greater expropriation likelihood. The perfor-mance of these firms should be worse than the aver-age firm.

Mitton measures the quality of governance in twosimple ways. First, he examines whether the firm hascross listed its stock in the U.S. in the form of anAmerican Depository Receipt (ADR). As we discussedearlier, this imposes stricter disclosure standards andmakes the firm more transparent to outside inves-tors. The second measure is the auditor used by thefirm. Mitton separates the companies into two cat-egories: those which use major accounting firms,such as Ernst and Young, and companies which useother accounting firms.

His results provide strong evidence that gover-nance and the transparency of financial statementsare valued in emerging markets. After controlling forcountry- and industry-specific factors, firms thathave ADRs produced returns that were 10.8% higherthan other emerging market firms from July 1997 toAugust 1998. In addition, if the company’s auditorwas one of the major accounting firms, then thereturns to the company were higher by an additional8.1%. Mitton also reports that highly diversified ex-hibit returns are lower by 7.6%. This is attributed tothe likelihood that the strong subsidiaries will havetheir resources inefficiently diverted to support theweak subsidiaries.

For a long time, it was difficult for non-domesticinvestors to participate in many emerging markets.This was frustrating for non-domestic investors be-cause they were denied portfolio diversification andthe ability to pursue favorable investment oppor-tunities. The process of making equity marketsaccessible to non-domestic investors created anadditional incentive for good corporate governance.To attract external capital, they needed to satisfythe requirements of international investors.

Evidence proffered by Bekaert, Harvey, andLundblad (2005) suggests that corporate governancepolicies may also have macro-economic effects. Viaexamination of 95 countries, these authors find thatopening up the equity markets is associated with an

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annual increase in GDP of about 1% over a 5 yearperiod. In addition, for countries with a strong legaland institutional framework, the annual increasewas about 2.2%. Overall, this suggests that progresstoward meeting the disclosure requirements for theglobal financial markets can have a strong positiveimpact on a country’s economic growth.

A study by Klapper and Love (2004) considerswhether high quality domestic institutions and en-forcement of securities laws can substitute for cor-porate governance. These authors use a measure ofcorporate disclosure from Credit Lyonnais that cov-ers 25 different countries during 1999. Since theirdata only covers 1 year, the comparisons are acrossfirms and across countries.

Klapper and Love find several interesting results.Firms in countries with a higher degree of investorprotection exhibit a higher return on assets. Thissuggests that the legal environment is an importantcontributor to corporate governance and the prof-itability of corporate operations. In addition, withincountries, they find that firms with higher qualitycorporate governance have higher rates of prof-itability. This is consistent with the findings ofGompers, Ishii, and Metrick (2003) for the U.S.

The most interesting result occurs for firms withgood governance which are located in countries withpoor shareholder protection institutions. For thesefirms, the positive impact of corporate governanceon profitability is much stronger. These firms realizethat it is in their self-interest to meet the gover-nance requirements of the global financial markets,even if these actions are not required in their homecountry. Taking these additional steps will likelyincrease the value of the company, and increasethe interest from outside investors.

4. Final thoughts

In summary, there is compelling empirical evidencethat corporate governance matters. Not only do themarkets pay attention to corporate governance, butthey reward good governance and punish poor gov-ernance, which in turn is integral to CorporateSocial Responsibility.

Appendix

Our discussion of Enron is adapted from Healy andPalepu (2003). Please see their article for a com-plete analysis. Our discussion of Sarbanes-Oxleychanges is based on Appendix A in Jain and Rezaee(2006). Please see their article for additional detail.

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