Socially Responsible Firms

The desirability for corporations to engage in socially responsible behavior has long been hotly debated among economists, lawyers, and business experts. Back in the 1930s, two American lawyers, Adolf A. Berle, Jr., and E. Merrick Dodd, Jr., had a famous public debate addressing the question: to whom are corporations accountable? Berle argued that the management of a corporation should be held accountable only to shareholders for their actions, and Dodd argued that corporations were accountable to both the society in which they operated and their shareholders. The lasting interest in this debate reflects the fact that the issues it raises touch on the basic role and function of corporations in a capitalist society.

Two general views, often reflecting the issues raised in the Berle-Dodd debate, on corporate social responsibility (‘CSR’) prevail in the literature. The CSR good governance view argues that socially responsible firms, such as firms that promote efforts to help protect the environment, seek social equality, and improve community relations, can and often do adhere to value-maximizing corporate governance practices. As such, well-governed firms are more likely to be socially responsible. In short, CSR can be consistent with maximizing shareholder wealth as well as achieving broader societal goals. The opposite view on CSR begins with American economist Milton Friedman’s well-known claim that ‘the only responsibility of corporations is to make profits’ in a 1970 New York Times article. Extending this view, several researchers argue that CSR is often simply a manifestation of managerial agency problems inside the firm and, hence, problematic. That is, managers engage in CSR to benefit themselves at the expense of shareholders and lose focus on their core managerial responsibilities. Overall, according to the agency view, CSR is generally not in the interest of shareholders.

The empirical literature testing these two views is mixed and thus has left the issues raised in the Berle-Dodd debate largely unresolved. However, much of the literature is largely focused only on the ex post effects of CSR. That is, the principal research focus is on measuring shareholder reactions to CSR as captured by abnormal stock returns, the cost of capital, and ownership changes or on the financial consequences of CSR spending. However, both the good governance and agency views are concerned to a significant extent with managerial incentives, which are ex ante in nature. In the agency view, the managerial incentive to engage in CSR is a reflection of the generally poor incentives of managers at socially responsible firms, ie, these firms suffer from agency problems. These agency problems then manifest themselves in the form of, among others, CSR activities. In the good governance view, well-run firms, meaning firms in which management is generally properly incentivized, tend to have managers engaging in appropriate CSR conduct. In this way, the debate over CSR connects with the general corporate finance literature on agency problems and ex ante managerial incentives, a fact that we exploit in our empirical analyses.

In our paper, ‘Socially Responsible Firms’, we take a comprehensive look at the CSR agency and good governance views around the globe. By means of a rich and partly proprietary CSR data set with global coverage across a large number of countries and composed of thousands of the largest companies, we test these two views by examining whether traditional corporate finance proxies for firm agency problems, such as capital spending cash flows, managerial compensation arrangements, ownership structures, and country-level investor protection laws, account for firms’ CSR activities. While other studies using a within-country quasi-experimental approach focus on the marginal effect of variation in agency problems, our data and empirical setting enable us to examine its average effect. Based on this comprehensive analysis, we fail to find evidence that CSR conduct in general is a function of firm agency problems. Instead, consistent with the good governance view, well-governed firms, as represented by lower cash hoarding and capital spending, higher payout and leverage ratio, and stronger pay-for-performance, are more likely to be socially responsible and have higher CSR ratings. In addition, CSR is higher in countries with better legal protection of shareholder rights and in firms with smaller excess voting power held by controlling shareholders. Moreover, a higher CSR rating moderates the negative association between a firm’s managerial entrenchment and value. All these findings lend support to the good governance view and suggest that CSR in general is not inconsistent with shareholder wealth maximization.

Allen Ferrell is the Harvey Greenfield Professor of Securities Law at Harvard Law School.

Hao Liang is Assistant Professor of Finance at Singapore Management University (SMU).

Luc Renneboog is Professor of Corporate Finance at Tilburg University.