Review of Corporate Finance Studies

What drives the marginal dollar of “goodness” investment by managers: maximization of shareholder value or managerial agency conflicts? The CEOs backing the Business Roundtable’s “Statement on the Purpose of a Corporation that Serves All Americans” argue that Corporate Social Responsibility (CSR) should maximize shareholder value rather than be the outcome of agency conflicts. While it may be true that CSR, on average, will allow firms to do better by doing good, we should also consider the possibility that managers with social preferences may overinvest in goodness if they do not have the right incentives. Absent such constraints, managers may choose to do good with other people’s money, potentially damaging their fiduciary commitment toward shareholders.

Ing-Haw Cheng, Harrison Hong, and Kelly Shue investigate this question in their paper “Do Managers Do Good with Other People’s Money?” They answer the question by using the Jobs and Growth Tax Reconciliation Relief Act of 2003 (a dividend tax cut) and see how firms with different managerial ownership responded in their “goodness” investments to this dividend tax cut, which had a particularly strong effect on the after-tax ownership of managers. The authors use CEO’s ownership stake as a proxy for the alignment between insiders and shareholders and look at the nonlinearity in the relationship between managers’ alignment and firm valuation. Specifically, managers with medium ownership should respond relatively more to the dividend tax cut compared to those with very low (incentives hardly change in this case) or high ownership stakes (lower agency conflicts to start with, in this case).

The paper finds a number of interesting results. First, firms’ CSR scores fell on average after the 2003 tax cut, but those of firms with medium insider ownership fell significantly more than the rest. Second, the same firms with medium managerial ownership saw the strongest shareholder returns, even over longer horizons. These two results together show that we cannot underestimate the possibility of agency conflicts driving CSR in certain types of firms. Results are confirmed when the authors look at the cross-section of firms by their governance: improvements in managerial incentives are consistent with lower firm goodness.

Finally, the authors consider the idea that there may be a trade-off between better governance and social welfare: for example, shareholders of better governed firms can use their higher wealth to compensate for the CSR declines in their firm. The paper shows that this is unlikely to happen, at least in the context they consider.

Spotlight by Andrew Ellul
Photo courtesy of Ing-Haw Cheng, Harrison Hong, and Kelly Shue

“Activity shocks and corporate liquidity: the role of trade credit” by Benjamin Bureau, Anne Duquerroy, and Frédéric Vinas