Corporate governance, non- financial stakeholders and ... · PDF filewelfare of non-financial stakeholders beyond their opportunity cost? ... •How changes in the legal protection

Corporate governance, non-financial stakeholders and

innovation

Julian Atanassov

University of Oregon

1st CSEF Conference on Finance and Labor

Big picture: shareholder vs. stakeholder society

• M. Friedman (1970):

– The corporate executive is an employee of the owners and he is responsible to them:

• To make as much money for the owners as possible

• While conforming to the basic rules and norms of the society: both those embodied in law and those embodied in ethical custom

Tirole (2001)

• Unconventionally for an economist defines corporate governance as:

– The design of institutions that induce or force management to internalize the welfare of all stakeholders

– Managerial incentives have to account for the impact of all stakeholders – natural stakeholders and financial stakeholders

– Economists’ implicit assumption is that non-financial stakeholders are protected by powerful contracts and shareholders are the residual claimants

3

Questions

• Why do firms explicitly engage in “socially responsible” activities that improve the welfare of non-financial stakeholders beyond their opportunity cost?

• How would a change in the balance of power between shareholders and non-financial stakeholders affect firms’ long-term performance and financial policies?

4

Challenges

• Measure long-term firm performance • Derive implications for broader social wealth • Solution: use corporate innovation as a measure of

long-term performance: – Innovation has positive spillover effects on other firms and

the society overall – It is the most important driver of economic growth and

wealth creation in the society

• Endogeneity concerns: – Use exogenous measures of stakeholder and shareholder

protection – Use a setup related to hostile takeovers because the

conflict of interest between the two groups is severe in that case

5

The incomplete contract view

• Focusing primarily on shareholder value may inflict externalities on other stakeholders (Shleifer and Summers, 1988) – Short-term shareholder value may increase, but

– Reduced incentives of stakeholders may decrease long-term performance if these stakeholders invest less effort, time and money in acquiring long-term firm specific skills

– Predicts that an increase in stakeholder protection may improve long-term performance, especially when shareholders are strong (e.g. the threat of hostile takeovers is high)

6

The agency view

• Caring for stakeholders is a form of perk consumption • Managers restrain from restructuring the company and firing

workers because they dislike conflicts with workers and unions ((Jensen and Meckling, 1976; Bertrand and Mullainathan, 2003))

• Managers use stakeholders as allies against powerful shareholders (Pagano and Volpin, 2005)

– Managers engage in environmental and charitable causes to increase their popularity (e.g. Denis Kozlowski of Tyco Int.)

– Because of the cozy relations with stakeholders, managers are slow to respond to technological challenges, and have fewer resources to innovate

• Predicts that if stakeholder protection increases, firms will innovate less and have lower market value, especially if shareholders are weak (e.g. threat of hostile takeovers is low)

7

Main findings

• Important to look jointly at shareholder and stakeholder protection

• An increase in stakeholder protection has a differential impact for firms with weaker corporate governance relative to firms with stronger corporate governance – The number of stakeholder-friendly policies

increases – Innovation and firm value decline – Leverage increases

• For firms with good governance, however, greater stakeholder protection leads to higher innovation and firm value 8

Previous literature

• Corporate finance literature has predominantly focused on the relationship between shareholders and managers

• Recently, there has been a documenting that other stakeholders can significantly affect managerial behavior – These papers have focused mostly on labor: Bronars and

Deere, 1991, Matsa (2010), Chen et al. (2011a,b), Simintzi et al. (2013), Acharya et al. (2012), Tian (2013), etc.)

• This paper studies the interaction of shareholders with other stakeholders such as customers, the community and the natural environment, in addition to labor, on firm performance and financial policies

9

Data

• Stakeholder friendly corporate policies: KLD

• State constituency laws (CL) to measure the increase in stakeholder protection

• State business combination laws (BC) to measure the weakening of corporate governance

• Compustat for financial variables

• NBER patent dataset – for innovation

10

Constituency Laws

• Designed to protect stakeholders that might be adversely affected by corporate actions

• Permit corporate directors to consider stakeholder interests when making decisions

• Almost no research in finance that investigates their role in corporate governance

• Stakeholders are defined as: – Employees, customers, suppliers and creditors – Community and society – Natural environment

11

Business Combination Laws

• Business Combination laws – impose a moratorium on certain types of transactions (e.g. mergers and asset sales) between a large shareholder and the firm for a period of 3-5 years

• Widely recognized as reducing the power of shareholders vis-à-vis management by both the academic literature and by the lawsuits that followed their adoption

12

Stakeholder friendly policies

• Source: KLD

• 4 policy types

• 4889 firms

• 1991-2007

• Objective

Rankings

• Sold to and

used by investors 13

Stakeholder friendly policies

• Caring about the community

• Caring for employees

• Protecting the environment

• Improving product quality

14

Stakeholder Friendly Policies - Community

• Charitable giving – The company has consistently given more than 1.5% of trailing three-year net earnings before taxes to charities

• Innovative giving – Promoting self-sufficiency among economically disadvantaged

• Support for housing

• Support for education

• Indigenous peoples relations

15

Stakeholder Friendly Policies - Environment

• Derives substantial revenues from beneficial products and services

• Pollution prevention programs

• Recycling programs

• Clean energy

• Environmental transparency

• No waste liabilities that exceed $50 million, and no civil penalties for waste management violations

16

Stakeholder Friendly Policies - Employees

• Fair treatment of unions

• No-layoff policy

• Cash profit sharing program to majority of workforce

• Worker involvement through stock ownership

• Strong retirement benefits

• Strong health and safety programs

17

Performance of socially responsible index of firms vs. the S&P 500 index

18

19

Innovation

• Innovation is measured by:

– The number of patents

– The number of citations per patent

• Patent Citations

– Citations are very valuable (Hall, Jaffe, and Trajtenberg (2005), Atanassov (2013)

Table II: Summary Statistics

20

Stakeholder protection, Corporate Governance, and Stakeholder-friendly

Policies • Constituency Laws increase the number of

stakeholder friendly policies by 8.7% • BC laws reduce the number of stakeholder

friendly policies by 11.6% (consistent with Pagano and Volpin (2005))

• Constituency laws have a 27.7% greater impact on stakeholder-friendly policies for firms that have Business Combination laws than for firms that do not – The effect is strong for community, employee and

environmentally-friendly policies – There is no effect of stakeholder protection on

customer-friendly policies

21

Table IIIA

22

Table IIIB

23

Stakeholder protection, corporate governance and innovation

• The increase in stakeholder protection reduces both the number of patents (by 7.2%) and citations per patent (by 9.2%) for firms incorporated in states that pass BC laws relative to firms in states that do not pass BC laws

• The increase in stakeholder protection leads to 11.4% more citations per patent for firms with good governance (no BC laws)

• The number of stakeholder-friendly policies is negatively related to innovation

24

Table VA

25

Table VB

26

Market Value, Constituency Laws, and Business Combination Laws

• The increase in stakeholder protection reduces firm value (by 4.6%) for firms incorporated in states that pass BC laws relative to firms in states that do not pass BC laws

• The increase in stakeholder protection leads to 7.2% greater firm value for firms with good governance (no BC laws)

• The number of stakeholder-friendly policies is negatively related to firm value

27

Table VIA

28

Table VIB

29

Stakeholder protection, corporate governance and financial leverage

• The increase in stakeholder protection increases leverage (by 4.5%) and long-term leverage (by 9.4%) for firms incorporated in states that pass BC laws relative to firms in states that do not pass BC laws

• The increase in stakeholder protection leads to 3.4% greater leverage and 9.9% greater long-term leverage for firms with good governance (no BC laws) – The threat of hostile takeovers is enough to keep

stakeholders in check and firms have to reduce financial leverage to counterbalance the increase in operating leverage (Siminzi, Vig and Volpin (2013))

30

Table VII

31

Conclusion

• Managers are playing a delicate balancing game between their private benefits, and the interests of shareholders and different groups of non-financial stakeholders

• Overall support for the agency view is the strongest

• Partial support for the contracting view: • When shareholders are strong, an increase in

stakeholder protection leads to higher innovation and firm value:

– This result supports enlightened value maximization theory” (enlightened stakeholder theory) (Jensen, 2000)

32

Why managers care for stakeholders

• To increase their private benefits (Jensen and Meckling, 1976):

– Feel popular and loved

– Receive personal benefits from non-financial stakeholders

– Gain a strategic ally against powerful shareholders (Pagano and Volpin, 2005)

• To internalize externalities associated with incomplete contracts and therefore to improve stakeholder incentives (Tirole, 2001)

33

Incomplete Contract view II

• Focusing on non-financial stakeholder can be a long-term investment

• However, Stein (1988)

• Strong corporate governance and pressure from financial markets (e.g. hostile takeovers) can make managers myopic and invest less in non-financial stakeholders

• Predicts that:

– Innovation and firm value will increase when stakeholder protection increases, and decrease when shareholder protection increases

34

The agency view II

• Managers use stakeholders as allies against powerful shareholders (Pagano and Volpin, 2005)

• Predicts that managers will care more about stakeholders when shareholders are stronger

– E.g. when the threat of hostile takeovers is greater

• Predicts that when stakeholders are strong, managers will increase financial leverage to counter the strength of stakeholders (Bronars and Deere, 1991; Matsa, 2010)

– E.g. Airlines, Auto manufacturers

35

Goal of the paper

• Big picture: evaluate

• Show empirically • How changes in the legal protection of non-financial

stakeholders affects the degree to which firms implement policies to explicitly care for these stakeholders

• How changes in the protection of non-financial stakeholders affects innovation, firm value, and capital structure, conditional on the strength of corporate governance

36

Motivation

• Corporate finance literature has predominantly focused on the relationship between shareholders and managers

• Recently, there has been several papers documenting that other stakeholders can significantly affect managerial behavior – These papers have focused mostly on labor: Atanassov and

Kim, 2009; Bronars and Deere, 1991, Matsa (2010))

• This paper underscores the importance of the interaction between stakeholder power and shareholder power in influencing managerial behavior and firms’ financial and investment policies

37

KLD Coverage

• For each year beginning with 1991, KLD STATS provides a table of data with a collection of approximately 650 companies that comprise the Domini 400 Social SM Index and S&P 500® with one record for each company and columns indicating membership of each index.

• Beginning in 2001, KLD expanded its coverage universe to include all companies on the Russell 1000®.

• In 2003, KLD added full coverage of the Russell 3000®. • In addition to these indexes, KLD provides membership

data on its own proprietary social indexes including the Large Cap Social Index (LCS) and the Broad Market Social Index (BMS)

38

39

40

Methodology • Differences-in-differences and triple differences methodology • yiskt is either the number of stakeholder friendly policies, or

leverage, or patents, or citations per patent or the logarithm of market-to-book for firm i in state of incorporation s, in state of location k, at time t;

• CLst is a dummy variable equal to one if state s has passed a Constituency Law by time t

• BCst is a dummy variable equal to one if state s has passed a Business Combination law by time

Xiskt is a vector of firm specific control variables for firm i at time t, αt are time fixed effects and βt are firm fixed effects

Table IV

41