Corporate social responsibility: An umbrella or a puddle on a rainy day? Evidence surrounding corporate financial misconduct

Date01 January 2020
AuthorJohn Bae,Jongha Lim,Wonik Choi
Published date01 January 2020
DOIhttp://doi.org/10.1111/eufm.12235
Eur Financ Manag. 2020;26:77117. wileyonlinelibrary.com/journal/eufm © 2019 John Wiley & Sons Ltd.
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DOI: 10.1111/eufm.12235
ORIGINAL ARTICLE
Corporate social responsibility: An umbrella or
a puddle on a rainy day? Evidence surrounding
corporate financial misconduct
John Bae
1
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Wonik Choi
2
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Jongha Lim
3
1
Department of Finance, Martha &
Spencer Love School of Business, Elon
University, Elon, North Carolina
2
Department of Accounting, Mihaylo
College of Business and Economics,
California State University, Fullerton,
California
3
Department of Finance, Mihaylo College
of Business and Economics, California
State University, Fullerton, California
Correspondence
John Bae, Department of Finance,
Martha & Spencer Love School of
Business, Elon University, Elon, NC
27244.
Email: jbae@elon.edu
Abstract
We examine the way a fraudulent firms preand post
misconduct corporate social responsibility engagement
is associated with its stock performance to investigate
the reputational role of corporate social responsibility
(CSR). In the short term, firms with good CSR
performance suffer smaller market penalties upon the
revelation of financial wrongdoing, supporting the
buffer effect, as opposed to the backfire effect, of a good
social image. We also find that the misbehaving firms
postmisconduct CSR efforts are negatively associated
with delisting probabilities, and positively with stock
returns. These findings support the argument that
increasing postcrisis CSR engagement can be an
effective remedy for a damaged reputation.
KEYWORDS
corporate social responsibility, financial misconduct, insurance,
market penalty, reputation repair
JEL CLASSIFICATION
G30, G41, M14, M41
EUROPEAN
FINANCIAL MANAGEMENT
We would like to thank participants in presentations at the American Accounting Association Western Region
Meetings and the Financial Management Association Meetings, and an anonymous referee for helpful suggestions and
comments.
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INTRODUCTION
In recent decades, few topics have drawn more attention from both scholars and practitioners
than corporate social responsibility (CSR).
1
The latest survey by MIT Sloan Management Review
(Unruh et al., 2016) reveals that CSR is an essential consideration for both chief executives and
investors: nearly 90% of top executives responded that a sustainability strategy was essential to
remaining competitive, and 75% of senior executives in investment firms responded that a
companys good CSR performance mattered when making investment decisions, while nearly
half of the investors said they would not invest in a company with poor CSR performance.
Academics have responded to this burgeoning interest, spurring a large body of literature.
This encompasses various disciplines, such as management, economics, finance, accounting,
with most attention given to understanding the link between CSR and corporate financial
performance (CFP). However, evidence so far seems mixed (Margolis, Elfenbein, & Walsh,
2007), which is primarily attributed to the complicated and endogenous nature of the CSRCFP
relationship. In an attempt to resolve the mixed link between CSR and CFP, recent studies have
examined conditions under which firmsCSR investments lead to an increased financial
performance (e.g., Byun & Oh, 2018; Deng, Kang, & Low, 2013; Lins, Servaes, & Tamayo, 2017;
Servaes & Tamayo, 2013).
Besides the continuous efforts of unveiling the benefits of CSR in a form of incremental
gains, a growing body of research has started to pay attention to a new aspect of the CSRCFP
relationship, namely the insurance effects of CSR investments. Specifically, it is the notion that
CSR can help preserve rather than generate financial performance, especially during difficult
times (Godfrey, 2005; Peloza, 2006). This important dimension of benefits from CSR, however,
has been much less explored than incremental gains.
In this study, we fill the gap in the literature by examining the insurance value from CSR in
the context where its benefits (or costs) may be more prominent: a reputational crisis. There has
been very little exploration of the reputational role that CSR may play when a firm is facing
reputational crisis, such as the exposure of wrongdoing. Among various types of reputational
crises, we focus on the revelation of financial misconduct. The research that does examine CSR
in times of reputational crises appears in the marketing or communication literatures,
considering customers as the target stakeholders and product failures as the crises (e.g., Dean,
2004; Klein & Dawar, 2004; Lyon & Cameron, 2004). We extend understanding of the
reputational role of CSR by focusing on investors as the target stakeholders and financial
misconduct as the crisis.
We explore two questions: first, whether the firmsex ante investment in CSR before the
negative event affects the shortterm market reaction. This question relates to the reputational
role of premade CSR efforts in moderating the extent of market penalties upon revelation of
corporate financial misconduct. The second question is whether firmsex post investment in
CSR after the negative event remedies damaged reputations. In other words, we want to further
examine whether investment in CSR acts not only as a vaccination shot but also as a treatment
shot.
An important consideration in answering the first question is whether the value of
reputation is magnified or compromised in the face of a reputational crisis. On the one hand,
1
CSR closely relates to corporate sustainability, or a companys environmental, social, and governance performance. According to a KPMG (2013) report, 14% of
the worlds largest 100 firms use the term corporate responsibility,25% use corporate social responsibility,and 43% of firms use sustainability.However,
corporate social responsibilityis the dominant term in academic articles, and therefore we use it throughout this paper.
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FINANCIAL MANAGEMENT
BAE ET AL.
cognitive dissonance theory suggests that investors will rely even more heavily on reputation to
facilitate their decisionmaking in the face of elevated uncertainty, inflicting lower penalties on
firms with good reputations. We call this reputational advantage in cushioning the negative
market reaction during bad times the buffer effect.On the other hand, expectancy violation
theory indicates that investors will feel more betrayed by wrongdoing by firms of good repute,
and thus the exposure of misdeeds inflicts even more severe penalties on those firms. In other
words, a good image can increase the cost of inconsistent actions, which we call the backfire
effect.The observed outcome will tell us which cognitive mechanism dominates when
investors process new negative information about a firms misconduct.
In a sample of 491 firms that were subject to the Securities and Exchange Commission
(SEC)s Accounting and Auditing Enforcement Releases (AAERs),
2
we find evidence consistent
with a buffer (insurance) effect: firms with good prior CSR performance suffer significantly less
decline in market value, compared to those without the same standing. Moreover, we find the
buffer effect becomes stronger as the magnitude of financial misrepresentation worsens, a result
consistent with the prediction of cognitive dissonance theory.
With regard to our second research question, we find that an increase of CSR activities after
a crisis is negatively associated with the firms delisting probability, suggesting a possibility that
incremental CSR investments can help weather the storm caused by financial misconduct.
When interpreting this result, however, one should use caution, because the relationship
between a firms incremental CSR and financial performance in the postcrisis period is
endogenous and the causality can run in both directions. The observed relationship may result
from the fact that incremental CSR activities enhance the chance that the firm will survive
through the storm (by repairing its reputational capital). It is, however, also possible that a firm
may undertake additional CSR initiatives because a better financial situation enables it to afford
to. Simply put, at the heart of the issue is the debate over whether firms are doing well by doing
goodor rather doing good when doing well.
To address this possible endogeneity problem, we follow the approach employed by Lys,
Naughton, and Wang (2015). That is, we decompose incremental CSR into two components
the optimal and the deviation component to identify whether an increase in CSR is an
investment (doing well by doing good) or a signal (doing good when doing well). We find that
both investment and signaling effects exist in the CSRdelisting probabilities relationship. We
also examine how a firms postcrisis CSR engagement relates to its stock returns to find some
evidence that incremental CSR efforts have investment effects on stock returns. In sum, our
findings support the argument that postcrisis CSR engagement can be a remedy to repair
reputation damage and thus help the firm steer through the postmisconduct storm.
Our study belongs to the growing stream of research on the insurance value of CSR. For
example, Lins et al. (2017) show that investments in CSR pay off during crises (such as the
20082009 financial crisis), resulting in the excess performance for highCSR firms. Nofsinger
and Varma (2014) reach a similar conclusion by examining the value of CSR from investment
fundsperspective. Both of these studies, however, examine the insurance value of CSR during
the economywide crisis but when nothing is particularly wrong with the company. As such, in
the crisis settings tested in these papers, a firms CSR activities do not particularly contradict its
subsequent behavior. Therefore, cognitive dissonance or expectancy violation, the two
conflicting forces that lead us to predict the opposite effects of a good social image, are not
2
See section 3.1 for an explanation of the AAERbased sample.
BAE ET AL.EUROPEAN
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