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Corporate social responsibility, corporate governance, and financial performance: Lessons from finance
Business Horizons (2008) 51, 535—540
www.elsevier.com/locate/bushor
EXECUTIVE DIGEST
Corporate social responsibility, corporate governance, 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.
1. Just how influential is corporate social responsibility? What can management and, in particular, business ethics learn from recent research in finance? One of the problems with much of modern scholarship is that there is often little communication between various ‘‘academic silos.’’ The authors of this article have reviewed a range of recent studies published in the finance field. These studies suggest that firms practicing good ethics and good corporate governance are rewarded by the financial markets, while firms practicing poor ethics and poor corporate governance are punished. Corporate social responsibility (CSR) looks at how firms treat their stakeholders. One key stakeholder group that is frequently overlooked is the firm’s shareholders. All too often, the corporate social responsibility literature focuses on customers, employees, and the natural environment, but rarely on shareholders. The focus of this article is the impact of the firm on its shareholders as expressed through its corporate governance practices. If a firm can’t treat its shareholders well, what hope is there for the other stakeholders? Herein, we argue that there are market forces at work which reinforce good CSR * Corresponding author. E-mail addresses: [email protected] (R. Neal), [email protected] (P.L. Cochran).
behavior. A natural starting point is to examine the lessons from one of the most prominent bankruptcies in U.S. history.
1.1. Lessons from Enron In addition to being the largest bankruptcy in American corporate history, Enron is also a prime example of corporate social irresponsibility. In particular, Enron provides one of America’s most striking examples of stakeholder neglect. From 1998 to the end of 1999, Enron had been one of the stars of the financial markets. It was innovative and aggressive. It had an apparently well-structured business model and seemed to be very profitable. Then, in the space of a year, it all collapsed. The firm went from having a market capitalization of over $60 billion in January 2001, to bankruptcy less than 12 months later (see Appendix). How could this happen? Enron was founded in 1985 from the merger of two natural gas pipeline companies. At that time, the U.S. energy market was changing from regulated prices and low natural gas production to deregulated prices and dramatically expanded production. The market shifted from long-term fixed price contracts, to transactions based on the current spot market price. Both developments made Enron’s pipelines more valuable. The prices in the new spot markets, however, were more volatile and many natural gas customers
0007-6813/$ — see front matter # 2008 Kelley School of Business, Indiana University. All rights reserved. doi:10.1016/j.bushor.2008.07.002
536 were conservative utilities. Enron realized that it could position itself as an intermediary in the natural gas business. By absorbing much of the price risk, Enron could offer its customers long-term fixed price contracts that could help them manage the price risk of natural gas. This business model proved to be highly profitable; by the mid-1990s, Enron was accruing greater profits from its operations as a risk manager than from its pipeline operation. At about this same time, several other changes occurred. First, to maintain the company’s growth rate, Enron expanded into areas that were not closely related to its area of expertise as energy intermediaries. Enron designed and built power plants overseas, acquired paper and pulp factories, and purchased water utilities. While the existence of a diversification discount has been the subject of much research, recent findings (Mackey & Barney, 2005) have tended to support the original conclusion that unrelated acquisitions can reduce firm value. Second, Enron’s ‘‘off-balance-sheet’’ entries grew rapidly. Most of these entries were ‘‘derivative contracts’’ that were structured to offset the exposures that Enron faced from offering long-term natural gas contracts. Thus, Enron could reduce its exposure to future price volatility by locking in both costs and income. At this point, it would be useful to describe the difference between on-balance-sheet and off-balance-sheet items in U.S. financial statements. For many years, U.S. accounting required that only ‘‘tangible’’ items be represented on the balance sheet–— things such as physical plants and accounts due to be paid soon. Since the ultimate payoff of derivative contracts is difficult to predict, these contracts were relegated to the off-balance-sheet entries. As the number of off-balance-sheet entries grew, financial transparency suffered. It became increasingly more difficult to understand a firm’s economic exposure to such entries. Fortunately, recent accounting rule changes have improved the situation and made the financial statements more informative. Returning to Enron, the third development was adoption of accounting practices that ranged from very aggressive to clearly illegal. In one case, Enron created an off-balance-sheet company, whose profits were double-counted for both the company and Enron itself. When subsequent changes should have required Enron to consolidate the balance sheets, it violated the accounting rules and chose to keep the company off its balance sheet. When this problem was finally rectified, Enron was required to take a $1.4 billion write down. These developments–—especially the accounting fraud–—made it possible for Enron to disguise its true condition from investors. Arthur Andersen, the
EXECUTIVE DIGEST firm’s auditor, was heavily involved in consulting activities with Enron. Many have argued that these lucrative consulting contracts created a conflict of interest, and led Andersen to ignore the warning signs in Enron’s financial statements. Andersen clearly failed in its auditing role. In addition, Enron’s expansion into areas outside its expertise eventually produced losses for the company, and fraudulent accounting pumped up the profits of the energy trading business. It was a bubble waiting to burst. The lessons of Enron, however, go far beyond fraud and bankruptcy. It has forced us to ask: How could 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 carefully? What about professional investors like mutual funds and pension funds? What about the agencies that rated Enron’s bonds? Not only do all these parties have a vested interest in correct financial analysis, they also have fiduciary and legal obligations to get the analysis right. The parties are regulated by a variety of sources, including the U.S. Securities and Exchange Commission (SEC), the U.S. Federal Reserve Bank, the U.S. Department of Labor, the Financial Accounting Standards Board, and the New York Stock Exchange. In the words of Healy and Palepu (2003, p. 4): Despite this elaborate corporate governance and intermediation network, Enron was able to attract large sums of capital to fund a questionable business model, conceal its true performance through a series of accounting and financing maneuvers, and hype its stock to unsustainable levels. We believe that the problems of governance and incentives that emerged at Enron can also surface at many other firms, and may potentially affect the entire capital market.
2. An answer? The Sarbanes-Oxley Act of 2002 One reaction to the problems of Enron was the Sarbanes-Oxley Act. This law was adopted in 2002 as a response to growing frustration with corporate governance and the lack of transparency of financial statements among U.S. firms. The concerns were highlighted by the massive run-up and collapse of technology company stock prices and by the largest bankruptcies in U.S. corporate history. For example, the NASDAQ Composite Stock Index rose 180% from March 1998 to its peak in March 2000. Only 2 years later, all those gains had evaporated. In 2001 and 2002, 446 publicly traded firms with assets of $628 billion went bankrupt.
EXECUTIVE DIGEST The changes from the Sarbanes-Oxley Act fall primarily into three areas: auditing, financial reporting, and corporate governance (see Appendix). In the auditing area, the primary change was the creation of the Public Company Accounting Oversight Board, a regulatory organization designed to develop and enforce auditing standards. Other changes included strengthening the independence and authority of firms’ audit committees, disclosure of auditing fees and relationships, and limiting the ability of auditing firms to provide both auditing and consulting services to the same company. Under Sarbanes-Oxley, Chief Executive Officers and Chief Financial Officers are now required to personally certify the accuracy of the firm’s financial reports, and the SEC must review the statements every 3 years. The Act requires increased disclosure of off-balance-sheet items and contractual obligations, transactions between management and principle stockholders, and real-time disclosure of material changes in operating or financial condition. In the corporate governance area, firms must develop and disclose corporate codes of ethics, and assess the effectiveness of internal audit and risk management controls. CEOs and CFOs may be required to forfeit compensation if the firm has to restate its financial statements, and senior management faces additional criminal and civil penalties for defrauding shareholders.
3. Necessary changes? In the light of finance Were the changes introduced by Sarbanes-Oxley really necessary? Or were they an over-reaction to current events? Methodology used in Finance can address these questions from the perspective of at least one stakeholder group, namely stockholders, by looking at the stock price reaction to adoption of the new law. If a company’s stock price declines, then either the additional disclosure is not valued by investors or they consider it not worth the incremental costs. In either case, the costs of compliance reduce firm profits. If the stock price rises, however, then the additional disclosure is valued by investors and the increased transparency makes them more willing to purchase additional shares. With this in mind, the authors examined recent studies published in Finance journals to determine what light they might be able to shine on this question. A recent analysis by Jain and Rezaee (2006) examined these two alternatives. In the U.S., changes in law require a legislative process that usually takes years. The Sarbanes-Oxley Act,
537 however, was enacted very quickly, and so represents a significant unanticipated event to the financial markets. Jain and Rezaee examined the performance of stock indices on days when political developments increased the likelihood that the Act would be approved, and on days when the likelihood fell. They found that stock prices tended to rise when the likelihood increased, and fell when the likelihood decreased. Thus, the stock market reacted favorably to news of the additional disclosure and transparency requirements. Consistent with this finding, Jain and Rezaee conducted a second test whereby they used transparency and disclosure indices to measure the quality of a firm’s corporate governance. They found that firms with good governance had a positive price reaction to the new disclosure and transparency requirements, while those with poor governance had a negative reaction. Overall, the results suggest that good corporate governance is valued in the stock market and that investors are willing to pay more for a company with good governance principles. Another recent study indicated that good corporate governance is valued in the financial markets. Gompers, Ishii, and Metrick (2003) constructed a measure of the quality of corporate governance and relate the firm’s governance to its profitability, operating performance, and stock returns. Their governance measures are based on the ability of shareholders to monitor and control a firm’s management. Corporate policies that limit these abilities, such as poison pills to prevent hostile takeovers, and staggered boards that make it difficult to change a firm’s board of directors will give a firm a lower score in their quality index. Gompers and colleagues’ study examines 1,500 U.S. companies from 1990 to 1998. For each firm, they construct an aggregate measure of corporate governance based on 24 variables. Their results are quite striking. The firms that were classified as having very poor governance underperformed the market by 3.5% per year, while firms that were classified as very good outperformed the market by 5% per year. Thus, the difference between good and bad corporate governance in the U.S. is about 8.5% per year. These same authors find similar, but statistically less robust, results for other performance measures. Over the 1991 to 1999 period, firms that practiced good governance reported higher average profit margins, higher average sales growth, and higher average return on equity (ROE). Overall, the inference drawn from these results is that poor governance tends to produce poor firm performance. Likewise, good governance tends to produce good performance.
538 Yermack (2006) provides yet another perspective on how corporate governance is valued in the equity markets. He argues that agency problems–—conflicts of interest between the firm’s shareholders and the firm’s management–—are one of the most important governance challenges and reflect the quality of corporate governance. Yermack proposes a novel way of measuring the degree of agency problems by looking at the perks enjoyed by top management. While perks can be used as incentives to motivate managers, they can also reduce firm value if they are used too intensively. Yermack’s study focuses on the personal use of company aircraft by CEOs. In one extreme example, a firm provided senior management with 10 aircraft and 36 full-time pilots. The planes were frequently used by celebrities, golf instructors, family friends, and even pets. From 1993 to 2002, he finds that reported aircraft use tripled, a fact he attributes to both increased use and stronger SEC disclosure requirements. Yermack finds that the disclosure of personal aircraft use is associated with about a 1% initial decline in firm value and, over the next year, the firm underperforms the market by about 4%. Consistent with the idea that personal aircraft use is an indicator of agency problems and a measure of corporate governance quality, he finds that firms with aircraft are more likely to report large accounting write-offs. These firms are also more likely to report earnings that are significantly below the forecasts made by analysts. This pattern of the market reaction to corporate governance also shows up in other countries, as well. For example, Giannetti and Simonov (2006) examine how corporate governance influences investor ownership in Sweden. Using data from 2001, they construct several measures of corporate governance based on the likelihood that management will expropriate wealth from shareholders. In their approach, total profits from a firm can either be distributed to shareholders on a pro-rata basis or they can be used to disproportionately benefit corporate insiders. Giannetti and Simonov’s results show that the governance structure influences the pattern of equity ownership. After controlling for factors like size or dividends that are likely to affect ownership, they find that investors who are more likely to be expropriated–—small retail investors and foreign investors–—hold smaller stakes in weak governance companies. Likewise, investors that are more likely to receive the benefits of expropriation–—large domestic investors–—are more likely to hold larger stakes. When the takeover process starts, the bidding firm is willing to pay a price that is higher than the
EXECUTIVE DIGEST current market price of the target company. The ratio of the offer price to the market price just prior to the takeover announcement is called the takeover premium. In cases where a large percentage of the firm was acquired, firms with poor governance structures received a takeover premium of about 7% more than the good governance firms. Thus, even in Sweden–—a country with high governance standards and strict enforcement of securities laws–—expropriation risk significantly reduces the value of a firm. Another illustration of governance problems arises with the form of executive compensation. In the U.S., it is common for high-level executives to receive stock options as part of their overall compensation. The idea behind issuing these options is to align the interests of management and shareholders. According to this theory, if a significant portion of management’s wealth is the company stock, then the agency conflicts between shareholders and management are reduced. There is an important difference, however, between granting stock options to executives and granting them shares of the company. While both function to reduce agency problems, the payoff of the stock is symmetric; the gain from a $10 increase in the stock price is the same as the loss from a $10 decrease in price. In contrast, the payoff from a stock option is asymmetric. Because the option price is a convex function of the stock price, the gain to the option from a $10 increase in the stock price will exceed the loss from a $10 decrease. Burns and Kedia (2006) show that firms in which the CEO’s compensation is more heavily tilted toward stock options are likely to employ aggressive accounting standards. These authors compare a control group of firms to firms which were required to restate their earnings because of GAAP violations. Burns and Kedia find a strong positive association between the option delta and the likelihood of earnings restatement. (Option delta is a term that reflects the sensitivity of changes in the value of an option to changes in the underlying stock price. All else constant, the higher the delta, the greater the value of an employee stock option.) In other words, the greater the sensitivity of a CEO’s stock options to the underlying stock price, the greater the likelihood of earnings manipulation. The discussion of governance issues might create the impression that the U.S. governance and accounting systems are fundamentally flawed. At least relative to the other industrialized countries, this is clearly not the case. A global survey of comparative accounting systems and standards by Lang (2003) argues that the U.S. standards–—despite all their problems–—offer investors the most protection. Comparisons between common law-based countries
EXECUTIVE DIGEST (U.S., UK, Australia, and Canada) and code-based countries (most of Western Europe) suggest that common law systems provide outside investors a more transparent picture of corporate operations. For example, Ball, Kothari, and Robin (2000) find that countries whose legal systems are based on English common law tend to exhibit a stronger correlation between reported earnings and stock price reactions. This is interpreted as a measure of the informativeness of accounting disclosure. The logic is that if reported earnings are subject to manipulation by management, then investors will tend to discount the reported earnings, and thus the correlation between earnings and stock returns will be diminished. Among the common law countries, Ball and colleagues find that U.S. firms exhibit the strongest correlation, suggesting U.S. standards are the most informative. A similar conclusion is reached by Leuz, Nanda, and Wysocki (2003). These authors provide a comparison of earnings management across 31 countries. Their logic is that when companies smooth earnings over time, they provide a distorted picture of the company’s financial condition. In particular, bad times are hidden from investors by ‘‘borrowing’’ from future or past earnings. Leuz et al. examine several measures of earnings management and find that U.S. firms tend to have the lowest levels of earnings management, and thus the most informative earnings statements. This, of course, does not mean that U.S. firms don’t manage their earnings; it only means that U.S. firms have a lower degree of managed earnings than firms in other countries. Another type of comparison is provided in studies that examine firms which choose to cross list their stock. Firms that list on a stock exchange are required to meet the disclosure requirement of the exchange and the country; cross listing typically occurs when emerging market firms seek listing on more developed markets. In a comparison of firms that choose to cross list in the U.S., Miller (1999) finds that companies benefit from cross listing. On average, the value of the firm rises several percent from the dual listing. The inference is that the greater disclosure required by the U.S. markets offers investors more transparency and confidence in the reported financial statements. Cross listing thus offers firms the ability to certify that their reports meet the high standards of good corporate governance, and thereby increase their attractiveness to investors. Additional evidence comes from cross-sectional tests. There are several different ways firms can cross list in the U.S., and these different ways have different disclosure requirements. Miller finds a positive relation between the stock price reaction and the
539 degree of disclosure: firms that meet the stricter standards tend to exhibit the largest price increase. There are similar lessons in emerging markets. The scope of the empirical studies is, however, much more limited. One interesting study examines the impact of corporate governance among emerging market firms during the Asian Crisis of 1997-98. Mitton (2002) examines 398 firms across six different countries. He focuses on the potential expropriation of minority shareholders and argues that the crisis period increased the stress on companies, and made expropriation somewhat more likely. Accordingly, investors would avoid firms with poor governance and greater expropriation likelihood. The performance of these firms should be worse than the average firm. Mitton measures the quality of governance in two simple ways. First, he examines whether the firm has cross listed its stock in the U.S. in the form of an American Depository Receipt (ADR). As we discussed earlier, this imposes stricter disclosure standards and makes the firm more transparent to outside investors. The second measure is the auditor used by the firm. Mitton separates the companies into two categories: those which use major accounting firms, such as Ernst and Young, and companies which use other accounting firms. His results provide strong evidence that governance and the transparency of financial statements are valued in emerging markets. After controlling for country- and industry-specific factors, firms that have ADRs produced returns that were 10.8% higher than other emerging market firms from July 1997 to August 1998. In addition, if the company’s auditor was one of the major accounting firms, then the returns to the company were higher by an additional 8.1%. Mitton also reports that highly diversified exhibit returns are lower by 7.6%. This is attributed to the likelihood that the strong subsidiaries will have their resources inefficiently diverted to support the weak subsidiaries. For a long time, it was difficult for non-domestic investors to participate in many emerging markets. This was frustrating for non-domestic investors because they were denied portfolio diversification and the ability to pursue favorable investment opportunities. The process of making equity markets accessible to non-domestic investors created an additional incentive for good corporate governance. To attract external capital, they needed to satisfy the requirements of international investors. Evidence proffered by Bekaert, Harvey, and Lundblad (2005) suggests that corporate governance policies may also have macro-economic effects. Via examination of 95 countries, these authors find that opening up the equity markets is associated with an
540 annual increase in GDP of about 1% over a 5 year period. In addition, for countries with a strong legal and institutional framework, the annual increase was about 2.2%. Overall, this suggests that progress toward meeting the disclosure requirements for the global financial markets can have a strong positive impact on a country’s economic growth. A study by Klapper and Love (2004) considers whether high quality domestic institutions and enforcement of securities laws can substitute for corporate governance. These authors use a measure of corporate disclosure from Credit Lyonnais that covers 25 different countries during 1999. Since their data only covers 1 year, the comparisons are across firms and across countries. Klapper and Love find several interesting results. Firms in countries with a higher degree of investor protection exhibit a higher return on assets. This suggests that the legal environment is an important contributor to corporate governance and the profitability of corporate operations. In addition, within countries, they find that firms with higher quality corporate governance have higher rates of profitability. This is consistent with the findings of Gompers, Ishii, and Metrick (2003) for the U.S. The most interesting result occurs for firms with good governance which are located in countries with poor shareholder protection institutions. For these firms, the positive impact of corporate governance on profitability is much stronger. These firms realize that it is in their self-interest to meet the governance requirements of the global financial markets, even if these actions are not required in their home country. Taking these additional steps will likely increase the value of the company, and increase the interest from outside investors.
4. Final thoughts In summary, there is compelling empirical evidence that corporate governance matters. Not only do the markets pay attention to corporate governance, but they reward good governance and punish poor governance, which in turn is integral to Corporate Social Responsibility.
EXECUTIVE DIGEST
Appendix Our discussion of Enron is adapted from Healy and Palepu (2003). Please see their article for a complete analysis. Our discussion of Sarbanes-Oxley changes is based on Appendix A in Jain and Rezaee (2006). Please see their article for additional detail.
References Ball, R., Kothari, S. P., & Robin, A. (2000). The effect of international institutional factors on properties of accounting earnings. Journal of Accounting & Economics, 29(1), 1—51. Bekaert, G., Harvey, C. R., & Lundblad, C. (2005). Does financial liberalization spur growth? Journal of Financial Economics, 77(1), 3—55. Burns, N., & Kedia, S. (2006). The impact of performance-based compensation on misreporting. Journal of Financial Economics, 79(1), 35—67. Giannetti, M., & Simonov, A. (2006). Which investors fear expropriation? Evidence from investors’ portfolio choices. The Journal of Finance, 61(3), 1507—1547. Gompers, P., Ishii, J., & Metrick, A. (2003). Corporate governance and equity prices. The Quarterly Journal of Economics, 118(1), 107—155. Healy, P. M., & Palepu, K. G. (2003). The fall of Enron. The Journal of Economic Perspectives, 17(2), 3—26. Jain, P. K., & Rezaee, Z. (2006). The Sarbanes-Oxley Act of 2002 and capital-market behavior: Early evidence. Contemporary Accounting Research, 23(3), 629—654. Klapper, L., & Love, I. (2004). Corporate governance, investor protection, and performance in emerging markets (Working Paper No. 2818). Washington, DC: World Bank Policy Research. Lang, M. H. (2003). International accounting in light of Enron: Evidence from empirical research (Working Paper). Chapel Hill, NC: University of North Carolina. Leuz, C., Nanda, D., & Wysocki, P. D. (2003). Earnings management and investor protection: An international comparison. Journal of Financial Economics, 69(3), 505—527. Mackey, T., & Barney, J. (2005). Is there a diversification discount? Diversification, payout policy, and the value of a firm (Working Paper). Columbus, OH: The Ohio State University. Miller, D. P. (1999). The market reaction to international crosslistings: Evidence from depositary receipts. Journal of Financial Economics, 51(1), 103—123. Mitton, T. (2002). A cross-firm analysis of the impact of corporate governance on the East Asian financial crisis. Journal of Financial Economics, 64(2), 215—241. Yermack, D. (2006). Flights of fancy: Corporate jets, CEO perquisites, and inferior shareholder returns. Journal of Financial Economics, 80(1), 211—242.
www.elsevier.com/locate/bushor
EXECUTIVE DIGEST
Corporate social responsibility, corporate governance, 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.
1. Just how influential is corporate social responsibility? What can management and, in particular, business ethics learn from recent research in finance? One of the problems with much of modern scholarship is that there is often little communication between various ‘‘academic silos.’’ The authors of this article have reviewed a range of recent studies published in the finance field. These studies suggest that firms practicing good ethics and good corporate governance are rewarded by the financial markets, while firms practicing poor ethics and poor corporate governance are punished. Corporate social responsibility (CSR) looks at how firms treat their stakeholders. One key stakeholder group that is frequently overlooked is the firm’s shareholders. All too often, the corporate social responsibility literature focuses on customers, employees, and the natural environment, but rarely on shareholders. The focus of this article is the impact of the firm on its shareholders as expressed through its corporate governance practices. If a firm can’t treat its shareholders well, what hope is there for the other stakeholders? Herein, we argue that there are market forces at work which reinforce good CSR * Corresponding author. E-mail addresses: [email protected] (R. Neal), [email protected] (P.L. Cochran).
behavior. A natural starting point is to examine the lessons from one of the most prominent bankruptcies in U.S. history.
1.1. Lessons from Enron In addition to being the largest bankruptcy in American corporate history, Enron is also a prime example of corporate social irresponsibility. In particular, Enron provides one of America’s most striking examples of stakeholder neglect. From 1998 to the end of 1999, Enron had been one of the stars of the financial markets. It was innovative and aggressive. It had an apparently well-structured business model and seemed to be very profitable. Then, in the space of a year, it all collapsed. The firm went from having a market capitalization of over $60 billion in January 2001, to bankruptcy less than 12 months later (see Appendix). How could this happen? Enron was founded in 1985 from the merger of two natural gas pipeline companies. At that time, the U.S. energy market was changing from regulated prices and low natural gas production to deregulated prices and dramatically expanded production. The market shifted from long-term fixed price contracts, to transactions based on the current spot market price. Both developments made Enron’s pipelines more valuable. The prices in the new spot markets, however, were more volatile and many natural gas customers
0007-6813/$ — see front matter # 2008 Kelley School of Business, Indiana University. All rights reserved. doi:10.1016/j.bushor.2008.07.002
536 were conservative utilities. Enron realized that it could position itself as an intermediary in the natural gas business. By absorbing much of the price risk, Enron could offer its customers long-term fixed price contracts that could help them manage the price risk of natural gas. This business model proved to be highly profitable; by the mid-1990s, Enron was accruing greater profits from its operations as a risk manager than from its pipeline operation. At about this same time, several other changes occurred. First, to maintain the company’s growth rate, Enron expanded into areas that were not closely related to its area of expertise as energy intermediaries. Enron designed and built power plants overseas, acquired paper and pulp factories, and purchased water utilities. While the existence of a diversification discount has been the subject of much research, recent findings (Mackey & Barney, 2005) have tended to support the original conclusion that unrelated acquisitions can reduce firm value. Second, Enron’s ‘‘off-balance-sheet’’ entries grew rapidly. Most of these entries were ‘‘derivative contracts’’ that were structured to offset the exposures that Enron faced from offering long-term natural gas contracts. Thus, Enron could reduce its exposure to future price volatility by locking in both costs and income. At this point, it would be useful to describe the difference between on-balance-sheet and off-balance-sheet items in U.S. financial statements. For many years, U.S. accounting required that only ‘‘tangible’’ items be represented on the balance sheet–— things such as physical plants and accounts due to be paid soon. Since the ultimate payoff of derivative contracts is difficult to predict, these contracts were relegated to the off-balance-sheet entries. As the number of off-balance-sheet entries grew, financial transparency suffered. It became increasingly more difficult to understand a firm’s economic exposure to such entries. Fortunately, recent accounting rule changes have improved the situation and made the financial statements more informative. Returning to Enron, the third development was adoption of accounting practices that ranged from very aggressive to clearly illegal. In one case, Enron created an off-balance-sheet company, whose profits were double-counted for both the company and Enron itself. When subsequent changes should have required Enron to consolidate the balance sheets, it violated the accounting rules and chose to keep the company off its balance sheet. When this problem was finally rectified, Enron was required to take a $1.4 billion write down. These developments–—especially the accounting fraud–—made it possible for Enron to disguise its true condition from investors. Arthur Andersen, the
EXECUTIVE DIGEST firm’s auditor, was heavily involved in consulting activities with Enron. Many have argued that these lucrative consulting contracts created a conflict of interest, and led Andersen to ignore the warning signs in Enron’s financial statements. Andersen clearly failed in its auditing role. In addition, Enron’s expansion into areas outside its expertise eventually produced losses for the company, and fraudulent accounting pumped up the profits of the energy trading business. It was a bubble waiting to burst. The lessons of Enron, however, go far beyond fraud and bankruptcy. It has forced us to ask: How could 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 carefully? What about professional investors like mutual funds and pension funds? What about the agencies that rated Enron’s bonds? Not only do all these parties have a vested interest in correct financial analysis, they also have fiduciary and legal obligations to get the analysis right. The parties are regulated by a variety of sources, including the U.S. Securities and Exchange Commission (SEC), the U.S. Federal Reserve Bank, the U.S. Department of Labor, the Financial Accounting Standards Board, and the New York Stock Exchange. In the words of Healy and Palepu (2003, p. 4): Despite this elaborate corporate governance and intermediation network, Enron was able to attract large sums of capital to fund a questionable business model, conceal its true performance through a series of accounting and financing maneuvers, and hype its stock to unsustainable levels. We believe that the problems of governance and incentives that emerged at Enron can also surface at many other firms, and may potentially affect the entire capital market.
2. An answer? The Sarbanes-Oxley Act of 2002 One reaction to the problems of Enron was the Sarbanes-Oxley Act. This law was adopted in 2002 as a response to growing frustration with corporate governance and the lack of transparency of financial statements among U.S. firms. The concerns were highlighted by the massive run-up and collapse of technology company stock prices and by the largest bankruptcies in U.S. corporate history. For example, the NASDAQ Composite Stock Index rose 180% from March 1998 to its peak in March 2000. Only 2 years later, all those gains had evaporated. In 2001 and 2002, 446 publicly traded firms with assets of $628 billion went bankrupt.
EXECUTIVE DIGEST The changes from the Sarbanes-Oxley Act fall primarily into three areas: auditing, financial reporting, and corporate governance (see Appendix). In the auditing area, the primary change was the creation of the Public Company Accounting Oversight Board, a regulatory organization designed to develop and enforce auditing standards. Other changes included strengthening the independence and authority of firms’ audit committees, disclosure of auditing fees and relationships, and limiting the ability of auditing firms to provide both auditing and consulting services to the same company. Under Sarbanes-Oxley, Chief Executive Officers and Chief Financial Officers are now required to personally certify the accuracy of the firm’s financial reports, and the SEC must review the statements every 3 years. The Act requires increased disclosure of off-balance-sheet items and contractual obligations, transactions between management and principle stockholders, and real-time disclosure of material changes in operating or financial condition. In the corporate governance area, firms must develop and disclose corporate codes of ethics, and assess the effectiveness of internal audit and risk management controls. CEOs and CFOs may be required to forfeit compensation if the firm has to restate its financial statements, and senior management faces additional criminal and civil penalties for defrauding shareholders.
3. Necessary changes? In the light of finance Were the changes introduced by Sarbanes-Oxley really necessary? Or were they an over-reaction to current events? Methodology used in Finance can address these questions from the perspective of at least one stakeholder group, namely stockholders, by looking at the stock price reaction to adoption of the new law. If a company’s stock price declines, then either the additional disclosure is not valued by investors or they consider it not worth the incremental costs. In either case, the costs of compliance reduce firm profits. If the stock price rises, however, then the additional disclosure is valued by investors and the increased transparency makes them more willing to purchase additional shares. With this in mind, the authors examined recent studies published in Finance journals to determine what light they might be able to shine on this question. A recent analysis by Jain and Rezaee (2006) examined these two alternatives. In the U.S., changes in law require a legislative process that usually takes years. The Sarbanes-Oxley Act,
537 however, was enacted very quickly, and so represents a significant unanticipated event to the financial markets. Jain and Rezaee examined the performance of stock indices on days when political developments increased the likelihood that the Act would be approved, and on days when the likelihood fell. They found that stock prices tended to rise when the likelihood increased, and fell when the likelihood decreased. Thus, the stock market reacted favorably to news of the additional disclosure and transparency requirements. Consistent with this finding, Jain and Rezaee conducted a second test whereby they used transparency and disclosure indices to measure the quality of a firm’s corporate governance. They found that firms with good governance had a positive price reaction to the new disclosure and transparency requirements, while those with poor governance had a negative reaction. Overall, the results suggest that good corporate governance is valued in the stock market and that investors are willing to pay more for a company with good governance principles. Another recent study indicated that good corporate governance is valued in the financial markets. Gompers, Ishii, and Metrick (2003) constructed a measure of the quality of corporate governance and relate the firm’s governance to its profitability, operating performance, and stock returns. Their governance measures are based on the ability of shareholders to monitor and control a firm’s management. Corporate policies that limit these abilities, such as poison pills to prevent hostile takeovers, and staggered boards that make it difficult to change a firm’s board of directors will give a firm a lower score in their quality index. Gompers and colleagues’ study examines 1,500 U.S. companies from 1990 to 1998. For each firm, they construct an aggregate measure of corporate governance based on 24 variables. Their results are quite striking. The firms that were classified as having very poor governance underperformed the market by 3.5% per year, while firms that were classified as very good outperformed the market by 5% per year. Thus, the difference between good and bad corporate governance in the U.S. is about 8.5% per year. These same authors find similar, but statistically less robust, results for other performance measures. Over the 1991 to 1999 period, firms that practiced good governance reported higher average profit margins, higher average sales growth, and higher average return on equity (ROE). Overall, the inference drawn from these results is that poor governance tends to produce poor firm performance. Likewise, good governance tends to produce good performance.
538 Yermack (2006) provides yet another perspective on how corporate governance is valued in the equity markets. He argues that agency problems–—conflicts of interest between the firm’s shareholders and the firm’s management–—are one of the most important governance challenges and reflect the quality of corporate governance. Yermack proposes a novel way of measuring the degree of agency problems by looking at the perks enjoyed by top management. While perks can be used as incentives to motivate managers, they can also reduce firm value if they are used too intensively. Yermack’s study focuses on the personal use of company aircraft by CEOs. In one extreme example, a firm provided senior management with 10 aircraft and 36 full-time pilots. The planes were frequently used by celebrities, golf instructors, family friends, and even pets. From 1993 to 2002, he finds that reported aircraft use tripled, a fact he attributes to both increased use and stronger SEC disclosure requirements. Yermack finds that the disclosure of personal aircraft use is associated with about a 1% initial decline in firm value and, over the next year, the firm underperforms the market by about 4%. Consistent with the idea that personal aircraft use is an indicator of agency problems and a measure of corporate governance quality, he finds that firms with aircraft are more likely to report large accounting write-offs. These firms are also more likely to report earnings that are significantly below the forecasts made by analysts. This pattern of the market reaction to corporate governance also shows up in other countries, as well. For example, Giannetti and Simonov (2006) examine how corporate governance influences investor ownership in Sweden. Using data from 2001, they construct several measures of corporate governance based on the likelihood that management will expropriate wealth from shareholders. In their approach, total profits from a firm can either be distributed to shareholders on a pro-rata basis or they can be used to disproportionately benefit corporate insiders. Giannetti and Simonov’s results show that the governance structure influences the pattern of equity ownership. After controlling for factors like size or dividends that are likely to affect ownership, they find that investors who are more likely to be expropriated–—small retail investors and foreign investors–—hold smaller stakes in weak governance companies. Likewise, investors that are more likely to receive the benefits of expropriation–—large domestic investors–—are more likely to hold larger stakes. When the takeover process starts, the bidding firm is willing to pay a price that is higher than the
EXECUTIVE DIGEST current market price of the target company. The ratio of the offer price to the market price just prior to the takeover announcement is called the takeover premium. In cases where a large percentage of the firm was acquired, firms with poor governance structures received a takeover premium of about 7% more than the good governance firms. Thus, even in Sweden–—a country with high governance standards and strict enforcement of securities laws–—expropriation risk significantly reduces the value of a firm. Another illustration of governance problems arises with the form of executive compensation. In the U.S., it is common for high-level executives to receive stock options as part of their overall compensation. The idea behind issuing these options is to align the interests of management and shareholders. According to this theory, if a significant portion of management’s wealth is the company stock, then the agency conflicts between shareholders and management are reduced. There is an important difference, however, between granting stock options to executives and granting them shares of the company. While both function to reduce agency problems, the payoff of the stock is symmetric; the gain from a $10 increase in the stock price is the same as the loss from a $10 decrease in price. In contrast, the payoff from a stock option is asymmetric. Because the option price is a convex function of the stock price, the gain to the option from a $10 increase in the stock price will exceed the loss from a $10 decrease. Burns and Kedia (2006) show that firms in which the CEO’s compensation is more heavily tilted toward stock options are likely to employ aggressive accounting standards. These authors compare a control group of firms to firms which were required to restate their earnings because of GAAP violations. Burns and Kedia find a strong positive association between the option delta and the likelihood of earnings restatement. (Option delta is a term that reflects the sensitivity of changes in the value of an option to changes in the underlying stock price. All else constant, the higher the delta, the greater the value of an employee stock option.) In other words, the greater the sensitivity of a CEO’s stock options to the underlying stock price, the greater the likelihood of earnings manipulation. The discussion of governance issues might create the impression that the U.S. governance and accounting systems are fundamentally flawed. At least relative to the other industrialized countries, this is clearly not the case. A global survey of comparative accounting systems and standards by Lang (2003) argues that the U.S. standards–—despite all their problems–—offer investors the most protection. Comparisons between common law-based countries
EXECUTIVE DIGEST (U.S., UK, Australia, and Canada) and code-based countries (most of Western Europe) suggest that common law systems provide outside investors a more transparent picture of corporate operations. For example, Ball, Kothari, and Robin (2000) find that countries whose legal systems are based on English common law tend to exhibit a stronger correlation between reported earnings and stock price reactions. This is interpreted as a measure of the informativeness of accounting disclosure. The logic is that if reported earnings are subject to manipulation by management, then investors will tend to discount the reported earnings, and thus the correlation between earnings and stock returns will be diminished. Among the common law countries, Ball and colleagues find that U.S. firms exhibit the strongest correlation, suggesting U.S. standards are the most informative. A similar conclusion is reached by Leuz, Nanda, and Wysocki (2003). These authors provide a comparison of earnings management across 31 countries. Their logic is that when companies smooth earnings over time, they provide a distorted picture of the company’s financial condition. In particular, bad times are hidden from investors by ‘‘borrowing’’ from future or past earnings. Leuz et al. examine several measures of earnings management and find that U.S. firms tend to have the lowest levels of earnings management, and thus the most informative earnings statements. This, of course, does not mean that U.S. firms don’t manage their earnings; it only means that U.S. firms have a lower degree of managed earnings than firms in other countries. Another type of comparison is provided in studies that examine firms which choose to cross list their stock. Firms that list on a stock exchange are required to meet the disclosure requirement of the exchange and the country; cross listing typically occurs when emerging market firms seek listing on more developed markets. In a comparison of firms that choose to cross list in the U.S., Miller (1999) finds that companies benefit from cross listing. On average, the value of the firm rises several percent from the dual listing. The inference is that the greater disclosure required by the U.S. markets offers investors more transparency and confidence in the reported financial statements. Cross listing thus offers firms the ability to certify that their reports meet the high standards of good corporate governance, and thereby increase their attractiveness to investors. Additional evidence comes from cross-sectional tests. There are several different ways firms can cross list in the U.S., and these different ways have different disclosure requirements. Miller finds a positive relation between the stock price reaction and the
539 degree of disclosure: firms that meet the stricter standards tend to exhibit the largest price increase. There are similar lessons in emerging markets. The scope of the empirical studies is, however, much more limited. One interesting study examines the impact of corporate governance among emerging market firms during the Asian Crisis of 1997-98. Mitton (2002) examines 398 firms across six different countries. He focuses on the potential expropriation of minority shareholders and argues that the crisis period increased the stress on companies, and made expropriation somewhat more likely. Accordingly, investors would avoid firms with poor governance and greater expropriation likelihood. The performance of these firms should be worse than the average firm. Mitton measures the quality of governance in two simple ways. First, he examines whether the firm has cross listed its stock in the U.S. in the form of an American Depository Receipt (ADR). As we discussed earlier, this imposes stricter disclosure standards and makes the firm more transparent to outside investors. The second measure is the auditor used by the firm. Mitton separates the companies into two categories: those which use major accounting firms, such as Ernst and Young, and companies which use other accounting firms. His results provide strong evidence that governance and the transparency of financial statements are valued in emerging markets. After controlling for country- and industry-specific factors, firms that have ADRs produced returns that were 10.8% higher than other emerging market firms from July 1997 to August 1998. In addition, if the company’s auditor was one of the major accounting firms, then the returns to the company were higher by an additional 8.1%. Mitton also reports that highly diversified exhibit returns are lower by 7.6%. This is attributed to the likelihood that the strong subsidiaries will have their resources inefficiently diverted to support the weak subsidiaries. For a long time, it was difficult for non-domestic investors to participate in many emerging markets. This was frustrating for non-domestic investors because they were denied portfolio diversification and the ability to pursue favorable investment opportunities. The process of making equity markets accessible to non-domestic investors created an additional incentive for good corporate governance. To attract external capital, they needed to satisfy the requirements of international investors. Evidence proffered by Bekaert, Harvey, and Lundblad (2005) suggests that corporate governance policies may also have macro-economic effects. Via examination of 95 countries, these authors find that opening up the equity markets is associated with an
540 annual increase in GDP of about 1% over a 5 year period. In addition, for countries with a strong legal and institutional framework, the annual increase was about 2.2%. Overall, this suggests that progress toward meeting the disclosure requirements for the global financial markets can have a strong positive impact on a country’s economic growth. A study by Klapper and Love (2004) considers whether high quality domestic institutions and enforcement of securities laws can substitute for corporate governance. These authors use a measure of corporate disclosure from Credit Lyonnais that covers 25 different countries during 1999. Since their data only covers 1 year, the comparisons are across firms and across countries. Klapper and Love find several interesting results. Firms in countries with a higher degree of investor protection exhibit a higher return on assets. This suggests that the legal environment is an important contributor to corporate governance and the profitability of corporate operations. In addition, within countries, they find that firms with higher quality corporate governance have higher rates of profitability. This is consistent with the findings of Gompers, Ishii, and Metrick (2003) for the U.S. The most interesting result occurs for firms with good governance which are located in countries with poor shareholder protection institutions. For these firms, the positive impact of corporate governance on profitability is much stronger. These firms realize that it is in their self-interest to meet the governance requirements of the global financial markets, even if these actions are not required in their home country. Taking these additional steps will likely increase the value of the company, and increase the interest from outside investors.
4. Final thoughts In summary, there is compelling empirical evidence that corporate governance matters. Not only do the markets pay attention to corporate governance, but they reward good governance and punish poor governance, which in turn is integral to Corporate Social Responsibility.
EXECUTIVE DIGEST
Appendix Our discussion of Enron is adapted from Healy and Palepu (2003). Please see their article for a complete analysis. Our discussion of Sarbanes-Oxley changes is based on Appendix A in Jain and Rezaee (2006). Please see their article for additional detail.
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