The Effect of Corporate Governance on Corporate Social Responsibility

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rate social responsibility (CSR), using the governance standards provided by ... CSR and are forced to reduce CSR investments when corporate governance is ...
Asia-Pacific Journal of Financial Studies (2016) 45, 102–123

doi:10.1111/ajfs.12121

The Effect of Corporate Governance on Corporate Social Responsibility* Pandej Chintrakarn Business Administration Division, Mahidol University International College

Pornsit Jiraporn School of Graduate Professional Studies, Pennsylvania State University and College of Management, Mahidol University, The National Institute of Development Administration

Jang-Chul Kim Haile/US Bank College of Business, Northern Kentucky University

Young Sang Kim** Haile/US Bank College of Business, Northern Kentucky University Received 27 July 2015; Accepted 28 December 2015

Abstract Motivated by agency theory, we explore the effect of corporate governance quality on corporate social responsibility (CSR), using the governance standards provided by Institutional Shareholder Services (ISS). Our evidence reveals that firms with more effective governance make significantly less investment in CSR. It appears that managers tend to over-invest in CSR and are forced to reduce CSR investments when corporate governance is more effective. In particular, an improvement in governance quality by one standard deviation translates into a decline in CSR investments by 7.16%. Our fixed-effects analysis also shows that, within firms, when governance quality improves over time, CSR investments decline significantly. Using the passage of the Sarbanes-Oxley Act of 2002 as an exogenous shock that improves the quality of corporate governance, we demonstrate that high-quality governance is not merely associated with, but rather brings about, lower CSR investments. Keywords Corporate governance; Corporate Social Responsibility; Institutional Shareholder Services; Agency theory JEL Classification: G30, G34 *Acknowledgments: We wish to thank two anonymous referees and the Editor Hee-Joon Ahn for their valuable comments. We also thank Alain Krapl, Ha-Chin Yi, and seminar participants at Penn State University, Northern Kentucky University, session participants at the FMA annual meeting and the 2015 Annual International Conference on Asia-Pacific Financial Markets, for their helpful comments. Any remaining errors are our own. ** Corresponding author: Young Sang Kim, Associate Professor of Finance, Northern Kentucky University, Highland Heights, KY 41099 USA. Tel: + 1-859-572-5160, Fax: 1-859-5726177, email: [email protected]. 102

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The Effect of Corporate Governance on CSR

1. Introduction Each year, corporations make enormous investments in activities related to corporate social responsibility (CSR). Mutual funds that pursue investment strategies based on CSR command billions of dollars around the world. Academic debate on the costs and benefits of CSR spans several disciplines, including management, finance, economics, and marketing. The literature in the past 30 years has produced a tremendous volume of research on the topic of CSR. Much of the literature has been dedicated to the intensely debated question: does CSR improve firm value?1 Surprisingly, despite the enormous volume of research in this area, the conclusion on the costs and benefits of CSR remains largely elusive.2 Another area of the literature takes an alternative approach. Instead of looking directly at the impact of CSR on firm value, several recent studies examine factors that influence CSR engagement. These studies seek to understand the motives behind CSR decisions. For instance, prior studies find that CSR engagement is influenced by ownership structure (Barnea and Rubin, 2010; Oh et al., 2011), by takeover provisions (Jo and Harjoto, 2011), by CEO characteristics (Borghesi et al., 2014), by managerial entrenchment (Surroca and Tribo, 2008; Jiraporn and Chintrakarn, 2013a,b; Johnson and Yi, 2014), and by analyst coverage (Borghesi et al., 2014). Following the literature in this area, our study investigates how CSR engagement is influenced by corporate governance. Due to the agency conflict, managers may not always act in the best interest of shareholders. Corporate governance mechanisms are put in place to alleviate the agency conflict. In firms with effective governance, managers are less likely and able to take actions that maximize their private benefits at the expense of shareholders. On the one hand, CSR can enhance the reputation of the firm and thus increase shareholders’ wealth.3 On the contrary, managers may over-invest in CSR simply to gain private benefits, such as personal reputation and media coverage, a wasteful deployment of resources that does not maximize shareholders’ welfare.4 By examining the link between corporate governance and CSR, we seek to understand whether managers engage in CSR activities primarily to enhance shareholders’ wealth or to expropriate from them. 1

Solomon and Hansen, 1985; Pava and Krausz, 1996; Preston and O’Bannon, 1997; Stanwick and Stanwick, 1998; Verschoor, 1998; Ruf et al., 2001; Bauer et al., 2002; Becchetti et al., 2009;. Margolis and Walsh (2003) offer an exhaustive review of the literature on CSR. 2 A number of recent studies also examine the effects of CSR on various corporate outcomes. For instance, CSR has been linked to the cost of capital (El Ghoul et al., 2011), to the cost of bank loans (Goss and Roberts, 2011), to M&A returns (Deng et al., 2013), and to access to finance (Cheng et al., 2014) etc. 3 Consistent with this notion, a number of prior studies find that CSR is beneficial to firm value (Orlitzky et al., 2003; Saiia et al., 2003; Godfrey, 2005). 4 Supporting this view are a number of previous studies that report either negative or insignificant effects of CSR on firm performance (Aupperle et al., 1985; McGuire et al., 1988; Wright and Ferris, 1997; Teoh et al., 1999). © 2016 Korean Securities Association

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We measure the quality of corporate governance, using broad-based governance metrics provided by the Institutional Shareholder Services (ISS). The ISS governance standards are investigated in several recent studies in accounting, finance, and law, thus highlighting their usefulness across diverse disciplines.5 We use the CSR data from the KLD database, which has been widely used in the literature. Our research contributes to several areas of the literature. First and foremost, we contribute to the fierce debate on the costs and benefits of CSR. Our evidence seems to support the agency view. Managers tend to over-invest in CSR and are forced to cut back on CSR investments when governance is more effective. Second, we also contribute to the literature that examines the effects of corporate governance on various corporate outcomes. We demonstrate that governance quality does influence the extent to which firms invest in CSR. Our study is the first to use broad-based comprehensive governance metrics to investigate this issue. Third, a number of recent studies investigate whether governance ratings provided by various organizations are relevant to firm outcomes. The ISS governance recommendations have received enormous attention as they are commercially successful and have inspired a number of activist shareholders to pressure their companies to make governance changes. We show that the governance attributes recommended by ISS do indeed have an impact on CSR engagement. Finally, we contribute to the literature on CSR-based investments. Billions of dollars are invested in mutual funds in which the investment strategies are based on CSR. A debate has continued over whether these CSR-based strategies are costly or beneficial to investors. While we do not assess this issue directly, our evidence has indirect implications, that is, investments in CSR appear to be driven, at least in part, by the agency conflict. Shareholders, perhaps, should view CSR investments with some skepticism as they continue to invest in these CSR-based mutual funds. Given the above implications of our results, our study should be of interest to several parties, including regulators, shareholder activists, CSR activists, or even public investors in general. 2. Literature Review The literature on CSR is vast and spans a number of disciplines. Therefore, we review only those studies that are directly pertinent to our research. A few recent studies investigate the effects of various governance factors on CSR. However, the empirical evidence is inconclusive. Barnea and Rubin (2010) find that, as insider ownership increases, the degree of CSR declines. Their interpretation is that managers over-invest in CSR for their private benefit (such as improving personal repu5

A number of other recent studies also make use of the governance data provided by the ISS. For example, Aggarwal et al. (2009) employ the ISS governance data to compare governance quality between United States and international firms. They find that minority shareholders benefit as governance quality improves.

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tation or gaining media coverage). However, as their ownership increases, they bear a larger cost associated with this value-reducing activity. As a result, there is less CSR engagement as insiders own a larger percentage of equity.6 Jo and Harjoto (2011) examine several governance mechanisms, such as ownership structure, takeover provisions (Gompers et al.’s [2003] Governance Index), board characteristics, and analyst coverage. In general, their results suggest that better governance is associated with more CSR engagement. Using lagged variables, they also show that the direction of causality runs from corporate governance to CSR, but not the reverse. Because of the positive effect of governance on CSR, they argue that CSR appears to be beneficial. Borghesi et al. (2014) study various factors that motivate manager to invest in CSR activities, including corporate governance. They document that companies with stronger institutional and insider ownership are less likely to invest in CSR, casting doubt on the notion that CSR investments are designed to promote shareholder value. Using Gompers et al.’s (2003) Governance Index as a proxy for governance quality, they do not find a significant effect of governance on CSR. Moreover, their results reveal that CEO-specific attributes, such as gender, age, political contributions, are related to CSR investments. To the extent that CSR engagement enhances shareholder wealth, it should be promoted by the CEO, regardless of their personal characteristics. Therefore, they conclude that CSR investments may not be driven solely by altruistic reasons. Rather, they are motivated, at least partially, by personal reasons specific to each individual CEO. Surroca and Tribo (2008) look at managerial entrenchment and corporate social performance in the international context. The evidence shows that firms with more managerial entrenchment engage more in CSR activities. The authors argue that entrenched managers court favor from stakeholders by promoting CSR. This argument is consistent with the entrenchment hypothesis developed by Cespa and Cestone (2007). According to this theory, CSR can be used as an entrenchment strategy by managers. In particular, faced with monitoring from shareholders, managers satisfy stakeholders by promoting CSR. In so doing, managers improve their job security by ensuring that stakeholders offer a degree of protection from displeased shareholders in case of a dismissal attempt. In addition, stakeholders themselves do have certain powers to penalize or even remove top executives. For instance, they can engage in costly boycotts and media campaigns or vote to remove top executives through their representatives on the board. By pleasing stakeholders, managers make it less likely that their employment is threatened by stakeholders. 6

This study is motivated by agency theory. Managers run the company on behalf of shareholders and therefore act as their agents. Managers are expected to act in the best interest of the shareholders. An agency conflict arises when they take actions that enhance their private benefits rather than those of shareholders. By providing managers with ownership stakes in the company, agency problems can be alleviated.

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Using a sample of Korean firms, Oh et al. (2011) investigate the effects of ownership on CSR. They hypothesize that different types of ownership possess heterogeneous motives and thus do not affect CSR the same way. They show a positive association between institutional ownership and CSR. Foreign ownership also shows a positive relation. Institutional shareholders, such as banks and pension funds, likely take a long-term perspective on the firm because they cannot easily sell their shares and leave the firm. Consequently, they support activities that foster long-term benefits such as CSR. By contrast, managerial ownership is inversely related to CSR, implying that insiders may use their stock ownership to obtain personal benefits at the expense of other stakeholders. The authors note that their findings are interesting because, unlike in the United States, many Korean companies are part of a large conglomerate or “chaebol” with a distinctive ownership structure. The above review of the recent literature clearly shows that the empirical evidence is far from conclusive. For instance, the effect of corporate governance on CSR as measured by Gompers et al.’s (2003) Governance Index is positive in Jo and Harjoto (2011). Yet, Borghesi et al. (2014) find that it is not significant. Similarly, the effect of institutional ownership on CSR is positive in Jo and Harjoto (2011) as well as in Oh et al. (2011). By contrast, Borghesi et al. (2014) find it to be negative. Evidently, further research in this area remains necessary. 3. Hypothesis Development 3.1. The Conflict Resolution Hypothesis This hypothesis argues that there are inherent conflicts among various stakeholders because different groups of stakeholders possess different objectives, which may be in conflict with one another. For instance, employees may demand high employment benefits. However, investments in employment benefits may reduce the return to shareholders, leading to an inherent tension between employees and shareholders. Left unresolved, these conflicts may have deleterious effects on firm performance. The adoption of CSR can be used as a mechanism to resolve the conflicts among various stakeholders. The conflict resolution view suggests that managers engage in CSR in order to resolve conflicts among stakeholders, with the ultimate aim of maximizing shareholders’ wealth (Jensen, 2001; Scherer and Palazzo, 2007). Therefore, this view argues that CSR is adopted in order to promote shareholders’ welfare. With effective corporate governance, managers are more likely to take actions that enhance shareholders’ wealth. As a result, the conflict resolution hypothesis predicts that effective governance is associated with a higher degree of CSR. In other words, there is expected to be a positive association between governance quality and CSR engagement. H1: Firms with more effective governance are more socially responsible. 106

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3.2. The Over-Investment/Agency Cost Hypothesis This view argues that managers engage in CSR activities in order to enhance their own private benefits. For example, CSR activities bring media coverage to the executives, thereby improving their reputation as responsible global citizens (Jo and Harjoto, 2011). This hypothesis views CSR investments as an agency problem, a wasteful deployment of corporate resources that increases private benefits but does not maximize shareholders’ welfare. Effective corporate governance makes it more difficult for managers to take opportunistic actions. Thus, to the extent that CSR investments represent wealth expropriation by managers, effective governance is expected to diminish the degree of CSR. There should be an inverse association between governance quality and CSR engagement. In support of this argument, Barnea and Rubin (2010) report that insider ownership is inversely related to CSR. Insiders induce firms to over-invest in CSR when they bear little cost of the CSR investments. As their ownership increases, they bear a larger share of the cost associated with CSR activities. As a result, managers reduce CSR engagement as their ownership rises. H2: Firms with more effective governance are less socially responsible

4. Sample Construction and Data Description 4.1. Sample Construction The original sample includes all firms reported by ISS from 2001 to 2004. ISS collects data on governance standards for a large number of firms.7 Then, we narrow down our sample by eliminating firms whose financial and accounting data do not exist on COMPUSTAT. Financial and utility firms are excluded because they are regulated, making their financial and governance characteristics incomparable to those of industrial firms.8 We obtain data on CSR from Kinder et al.’s (KLD’s) database. The KLD database is the most widely recognized and reliable database in the CSR literature, being referenced by over 40 peer-reviewed articles. Our final sample consists of 3434 firm-year observations from 2001 to 2004.9 One critical advantage of our sample is that it straddles the passage of the Sarbanes-Oxley Act of 2002, thereby allowing us to exploit the enactment of the law as an exogenous shock.

7

We start our sample period in 2001, which is the earliest year the data are available. We end the sample period in 2004 because, after 2004, ISS add several governance attributes to the database, making it difficult to compare the additional data after 2004 with the earlier period. For consistency, we select our sample period from 2001 to 2004. 8 SIC codes 6000–6999 and 4900–4999 respectively. 9 In a later section, we also execute robustness checks using Aggarwal et al.’s (2009) sample that runs through 2008. The results remain similar. © 2016 Korean Securities Association

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4.2. Corporate Social Responsibility Score One challenge for research in CSR is its measurement. Prior research uses a number of alternative CSR measures. However, KLD is the most recognized and accepted in the literature.10 KLD includes strength ratings and concern ratings for 13 dimensions: community, diversity, governance, employee relations, environment, human rights, product, alcohol, gambling, firearms, military, tobacco, and nuclear power.11 KLD assigns strengths and concerns in the first seven dimensions, whereas the final six dimensions are just exclusionary screens and firms can only register concerns in those categories. For instance, a company can receive credit for a strong environment policy at the same time a concern is registered for its environment record. We do not include the exclusionary screen as part of the total CSR score. The total of the strengths minus the concerns is the composite CSR score (Goss and Roberts, 2011). 4.3. Corporate Governance Metrics To gauge the strength of corporate governance, we employ year-end data on governance standards provided by the ISS. The scope of the governance data is very broad, encompassing 50 governance standards in eight categories as defined by the ISS. The eight categories include audit issues, board structure and composition, other charter and bylaw provisions, director education, executive and director compensation, director and officer ownership, progressive practices, and laws of the state of incorporation related to takeover defenses. The 50 governance standards and their eight categories are shown in the Appendix. The governance standards reported by ISS capture various dimensions of corporate governance. For instance, the Audit category includes four governance standards associated with auditor independence (composition of the audit committee, ratification at the annual meeting, consulting fees paid to auditors, and the company’s policies on auditor rotation). The Charter category consists of seven governance standards related to provisions for delaying or impeding takeovers. The Board category is composed of 17 governance standards related to the composition

10

Although there are other alternative measures of CSR, KLD is the most widely accepted. Other CSR measures can be found in Carroll (1991), Aupperle (1991), and Waddock and Graves (1997). 11 It could be argued that the corporate governance rating, which is part of the composite CSR score, shares some similarity with Gov-Score, inducing a mechanical association between the CSR score and Gov-Score. This is not much of a concern for a few reasons. First, the corporate governance score rated by KLD is based on different factors than those used by ISS. Second, even if they are correlated, such a bias would imply a positive mechanical relation. However, the results reported later in this paper show a robust negative relation between CSR and Gov-Score, in spite of the possible bias. Therefore, if anything, any potential bias would strengthen our conclusion, not weaken it. In any event, even when we exclude the corporate governance category from the composite CSR score, all the results remain consistent. 108

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and other characteristics of the board. Finally, two categories, Director Education and State, each consist of a single governance factor. We employ two metrics to gauge the aggregate strength of corporate governance. First, similar to Brown and Caylor (2006), we construct an index for each firm by assigning one point for each governance standard that is satisfied. We label this index “Gov-score.” We ascertain whether a specific governance standard is met using the minimum standard provided in the ISS Corporate Governance: Best Practices User Guide and Glossary (2003), shown in Appendix. Second, we employ the metric computed by the ISS to measure governance quality. We refer to this metric as “ISS-score.” Although constructed based on the same governance standards, the ISS-score is different from the Gov-score because it allows interaction terms that occur in combination with others. For instance, the ISS assigns more weight to a firm whose board consists of a majority of independent directors and whose key board panels (audit, nominating, and composition) are all composed of independent directors, than it assigns to each of those standards individually.12 It is important to note that Gov-score and ISS-score are better measures of corporate governance strength than the Governance Index, developed by Gompers et al. (2003) for several reasons. First, the ISS data are available for a much larger number of firms in more recent years. Second, the ISS data are available annually, rather than biannually. Third, the ISS data are much broader, and still encompass about half of the standards incorporated into the Gompers et al. Index. Finally, the ISS data include five of the six standards that are identified as most relevant for firm value (Bebchuk et al., 2009). Finally, the ISS data encompass both internal and external governance mechanisms whereas the Gompers Index includes only internal governance devices. Both internal and external governance should be considered when the impact of corporate governance is examined (Cremers and Nair, 2005).13

12

ISS-score, converted to a relative index, is now publicly available on financial websites under the registered trademark “Corporate Governance Quotient.” To compute a Corporate Governance Quotient (CGQ) for each firm, ISS analysts employ publicly available documents and website disclosure to gather data on 50 different issues in the following four broad rating categories: board of directors, audit, anti-takeover, and compensation/ownership. On the basis of this information and a scoring system developed by an external advisory panel and ISS, they compute a CGQ for each company. While each variable is assessed on an individual basis, some variables are also evaluated in combination under the supposition that corporate governance is improved by the presence of selected combinations of favorable governance provisions. 13 The governance metrics based on the ISS governance standards have been used in a number of recent studies. For instance, these governance metrics have been used to explain stock liquidity (Chung et al., 2010), dividend policy (Jiraporn et al., 2011), capital structure (Jiraporn et al., 2012), credit ratings and bond yields (Jiraporn et al., 2013), and the opportunistic timing of option grants (Chintrakarn et al., 2013). © 2016 Korean Securities Association

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4.4. Control Variables Based on the literature, we control for a number of firm characteristics that have been found to influence CSR. We control for firm size by including the log of total assets. Large firms tend to attract more attention and pressure to respond to stakeholders’ demands (Burke et al., 1986). Large firms are expected to show more social responsibility. We control for profitability by including the ratio of EBIT to total assets. Evidently, more profitable firms can better afford to be more socially responsible. We also include the ratio of debt to total assets to control for financial leverage. McWilliams and Siegel (2001) argue that R&D expenditures have an impact on CSR. Accordingly, we include the ratio of R&D expenditures to total assets. We include asset tangibility as a control variable because firms with fixed assets can use them as collateral when obtaining financing. In addition, firms with fixed assets experience less information asymmetry because it is easier to value firms with tangible assets. We control for cash distributions by including dividend payouts as a control variable. Furthermore, we control for advertising intensity by including the ratio of advertising expenditures to total assets. Because CSR promotes the reputation of the firm, it may substitute for advertising. We also control for corporate investments by including the ratio of capital expenditures to total assets. Firms that make heavy investments may have fewer funds left for CSR. The awareness of CSR has increased over the years. We thus control for variation over time in CSR by including year dummies. Finally, it is critical to account for possible industry effects. In an important study, Brammer and Millington (2003) show that CSR investments are influenced by industry type. We control for industry effects by creating industry dummies corresponding to the first two digits of the SIC code. 4.5. Summary Statistics Table 1 shows the summary statistics. The average Gov-score is 25.35, suggesting that the sample firms, on average, satisfy about half of the governance standards recommended by the ISS. The ISS-score averages 59.90. The average CSR score is 0.02, with a standard deviation of 2.08. Most sample firms seem to have about the same number of CSR strengths as CSR concerns. The total debt ratio and the EBIT ratio average 21.46% and 9.47% respectively. Capital expenditures as a percentage of total assets are 6.53% on average. 5. Results 5.1. The Effect of Corporate Governance on Corporate Social Responsibility Table 2 reports the regression results. Model 1 is an OLS regression where the CSR score is the dependent variable. We use robust t-statistics based on standard errors adjusted for clustering at the firm level. Gov-score exhibits a negative and significant coefficient. In Model 2, we replace Gov-score with ISS-score. Again, the coefficient of ISS-score is significantly negative. The evidence seems to be in favor of the 110

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Table 1 Summary statistics Gov-Score and ISS-Score are constructed based on the governance attributes provided by the Institutional Shareholder Services (ISS). The CSR score is based on the data from the KLD database.

Variable

Mean

SD

25th

Median

75th

Gov-score ISS-score CSR score Total assets ($M) Total debt/total assets EBIT/total assets Fixed assets/total assets Capital expenditures/Total assets R&D/total assets Advertising/total assets Dividends/total assets

25.35 59.90 0.02 5730 21.46% 9.47% 22.73% 6.53% 3.36% 1.14% 0.97%

6.54 12.57 2.08 24 640 17.58% 20.71% 21.47% 21.12% 6.65% 2.62% 2.88%

20.00 51.20 1.00 440 4.70% 4.61% 5.76% 2.14% 0.00% 0.00% 0.00%

25.00 60.93 0.00 1219 20.39% 9.03% 16.30% 3.77% 0.17% 1.09% 0.00%

31.00 69.25 1.00 3886 32.63% 15.27% 32.20% 6.56% 3.84% 1.09% 1.24%

Table 2 The effect of corporate governance on corporate social responsibility (CSR) Gov-Score and ISS-Score are constructed based on the governance attributes provided by the Institutional Shareholder Services (ISS). The CSR score is based on the data from the KLD database. The industry dummies are based on the first two digits of the SIC codes. *, **, *** denote statistical significance at the 10%, 5%, and 1% respectively.

Dependent variable

(1)

(2)

OLS (robust and

OLS (robust and

(3)

(4)

clustered by firm)

clustered by firm)

Fixed-effects

Fixed-effects

CSR

CSR

CSR

CSR

Constant

0.488 (0.21)

Ln (Gov-score)

0.837 ( 6.09)*** –

Ln (ISS-score)

0.167 ( 0.07) –

2.890 (3.31)*** 0.914 ( 9.63)***

0.547 ( 2.33)**

6.145 (6.52)*** – 0.873 ( 6.02)***

Ln (Total assets)

0.255 (4.55)***

0.266 (4.63)***

0.046 (0.35)

0.333 ( 2.67)***

Leverage

0.814 ( 2.41)**

0.781 ( 2.33)**

0.699 ( 1.79)*

0.140 ( 0.36)

EBIT/total assets

1.310 (4.90)***

1.304 (4.84)***

0.389 ( 1.33)

0.664 ( 2.26)**

Asset tangibility

0.044 ( 0.12)

0.034 (0.10)

0.338 ( 1.03)

0.315 ( 0.94)

Capital expenditures ratio

0.965 (4.04)***

0.953 (4.00)***

0.088 ( 0.16)

0.463 (0.84)

R&D/total assets

2.647 (3.26)***

2.759 (3.41)***

0.681 ( 0.52)

0.634 ( 0.47)

Advertising/total Assets

5.881 (2.62)***

5.731 (2.57)***

2.384 ( 0.51)

Dividend/total assets

5.038 (2.35)**

4.940 (2.32)**

0.271 (0.28)

Industry dummies Adjusted/pseudo R2

4.469 ( 0.95) 0.0247 ( 0.02)

Yes

Yes

No

No

14.0%

13.12%

77.52%

76.89%

agency view. More effective governance forces managers to act more in the interest of shareholders. Because we find that more effective governance is associated with less CSR, it appears that CSR investments confer at least some private benefits to © 2016 Korean Securities Association

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managers, and may not be viewed favorably by stockholders. Managers seem to over-invest in CSR and are forced to invest less in CSR when governance is more effective. We estimate that an increase in Gov-score by one standard deviation results in a 7.16% decline in CSR engagement.14 The effect of corporate governance on CSR is not only statistically significantly, but also appears to be economically meaningful as well. Therefore, the results lend support to the over-investment/ agency cost hypothesis. On the contrary, the conflict resolution hypothesis, which predicts that stronger governance leads to stronger CSR, is not supported.15 It is conceivable that our results may be driven by unobservable characteristics that are omitted in the model. To minimize this possible omitted-variable bias, we execute a fixed-effects analysis that helps control for unobservable characteristics that remain constant over time. Model 3 reports a fixed-effects regression. Gov-score shows a negative and significant coefficient. Model 4 is similar to Model 3 but includes ISS-score instead of Gov-score. The coefficient of ISS-score is significantly negative.16 The fixed-effects results are thus consistent with the OLS results and lend credence to the agency/over-investment hypothesis. The fixed-effects analysis essentially concentrates only on the variation over time and disregards the cross-sectional variation. Therefore, the fixed-effects results imply that, within firms, when governance quality improves over time, investments in CSR significantly decline. Our evidence reveals that firms with more effective governance make significantly less investment in CSR. In particular, an improvement in governance quality by one standard deviation results in a decline in CSR by 7.16%. The effect of corporate governance on CSR thus appears to be both statistically significant as well as economically meaningful. Conscious of the possible endogeneity bias, we perform additional analysis that seeks to minimize the effect of endogeneity. Our fixed-effects results show that, within firms, over time, as governance quality improves, investments in CSR fall significantly. Because a fixed-effects analysis is less vulnerable to the omitted-variable bias, our conclusion does not appear to be driven by unobservable characteristics. Furthermore, using the passage of the Sarbanes-Oxley Act in 2002 as an exogenous shock that improves governance quality without directly affecting CSR 14

The coefficient of Ln (Gov-score is) 0.837. The standard deviation of Ln (Gov-score) is 0.274. So, an increase in Gov-score by one standard deviation is association with a decline in CSR by 0.274*0.837 = 0.229. Given that the average Ln (Gov-score) is 3.197, a change by 0.229 represents 7.16% of the average. 15 It is worth noting that the coefficients of the industry dummies are generally significant (not shown in the table, but available upon request). CSR investments appear to vary by industry, supporting the findings in Brammer and Millington (2003). 16 Because each sample firm remains in the same industry throughout the sample period, there is no variation in terms of industry across time. As a result, it is not possible to include industry dummies in the fixed-effects regressions. 112

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investment, our 2SLS results confirm that an improvement in governance quality is not merely associated with, but rather brings about, lower investments in CSR. Furthermore, we also investigate which aspects of corporate governance have more influence on CSR investments than others. The results show that four categories of governance have stronger effects than others do, that is, Board, Audit, Compensation, and Progressive (practice). These results deepen our understanding about the differential effects of various governance categories. In addition, to ensure that our results are robust, we execute a number of additional robustness checks. First, it is possible that firms strive only to have a positive CSR score. Once they are perceived as socially responsible by having a positive CSR score, they may be less motivated to invest further in CSR. In other words, investments in CSR may exhibit a threshold effect. To address this possible threshold effect, we construct a dichotomous variable equal to one if the CSR score is positive and zero otherwise. So, this variable is equal to one regardless of how positive the CSR score is. The logistic regression results are shown in Table 3. Models 1 and 2 have the CSR dummy as the dependent variable. Both Gov-score and ISS-score carry negative and significant coefficients. The marginal effect of corporate governance quality on the probability of being socially responsible (having a positive CSR score) is 19.85%, which seems to be economically significant.17 In addition, to further exploit the panel nature of our data, we run a random-effects analysis as a robustness check. The random-effects regressions are shown in Models 3 and 4. The coefficients of Gov-score as well as ISS-score are both negative and significant, corroborating the results obtain earlier. Additionally, to ensure that our results are robust to industry effects (Brammer and Millington, 2003), we run regressions for specific industries. The effect of corporate governance quality remains significant. As further robustness checks, we gauge governance quality using an alternative method based on Aggarwal et al. (2009). In particular, Aggarwal et al.’s (2009) measure of governance quality based on the percentage of total governance standards satisfied by the firm. For instance, if a firm satisfies 40 governance standards out of a total of 50, its governance score would be 40/50 = 0.80. We follow their method and label the new governance score as “modified Gov-score”. Models 5 and 6 in Table 3 show the results based on the modified Gov-score. Model 5 is an OLS regression. The coefficient of the modified Gov-score is significantly negative. Model 6 is a fixed-effect regression. Again, the modified Gov-score is negative and significant. Thus, even when we employ an alternative method to gauge governance quality, we continue to obtain consistent results. In addition, because ISS adds and drops several governance recommendations over time, our sample ends in 2004 when several changes are made, making it difficult to construct consistent governance indices for a later period. To ensure robustness, we explore a more recent period using the data provided by Aggarwal et al. 17

We compute the marginal effect as the slope of the logistic regression line, while holding all the variables at their means.

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Constant Ln (Gov-score) Ln (ISS-score) Modified Govscore (Based on Aggarwal et al., 2009) Ln (total assets) Leverage EBIT/total assets Asset tangibility Capital expenditures ratio R&D/total assets Advertising/total assets Dividend/total assets Industry dummies Adjusted/pseudo R2

Dependent variable

3.043 (3.90)*** 4.893 (3.06)*** 4.387 (2.67)*** Yes 8.99%

2.965 (3.77)*** 5.090 (3.17)***

4.550 (2.74)*** Yes 9.24%

(10.19)*** ( 3.38)*** (4.55)*** (0.07) (1.64)

0.315 0.954 1.700 0.019 0.546

0.306 0.966 1.709 0.019 0.528

(10.16)*** ( 3.41)*** (4.59)*** ( 0.07) (1.58)

0.881 ( 0.70) – 0.398 ( 2.09)** –

Logit CSR dummy

Logit CSR dummy

0.629 ( 0.55) 0.541 ( 3.72)*** – –

(2)

(1)

(8.09)*** ( 3.38)*** (2.52)*** ( 0.81) (2.36)**

1.788 (2.04)** Yes 12.92%

1.114 (1.73)* 3.705 (2.19)**

0.255 0.807 0.482 0.181 0.442

1.180 (0.95) 0.964 ( 12.27)*** – –

Random-effects CSR

(3)

(7.83)*** ( 2.34)** (2.43)** ( 0.37) (2.43)**

1.679 (1.88)* Yes 11.90%

1.293 (1.98)** 3.366 (1.98)**

0.252 0.562 0.473 0.084 0.460

1.425 (1.09) – 0.857 ( 7.02)*** –

Random-effects CSR

(4)

(4.59)*** ( 2.17)** (4.64)*** ( 0.11) (3.96)***

5.097 (2.36)** Yes 13.91%

2.731 (3.36)*** 5.917 (2.63)***

0.256 0.691 1.265 0.037 0.939

1.339 ( 0.58) – – 1.755 ( 6.05)***

(5) OLS (robust and clustered by firm) CSR

(0.41) ( 1.82)* ( 1.44) ( 1.13) ( 0.16)

0.257 (0.26) Yes 77.55%

0.644 ( 0.49) 2.532 ( 0.55)

0.055 0.709 0.418 0.372 0.089

0.900 (0.97) – – 1.975 ( 9.78)***

Fixed-Effects CSR

(6)

Gov-Score and ISS-Score are constructed based on the governance attributes provided by the Institutional Shareholder Services (ISS). Modified Gov-score is based on Aggarwal et al. (2009). The CSR score is based on the data from the KLD database. The industry dummies are based on the first two digits of the SIC codes. *, **, *** denote statistical significance at the 10%, 5%, and 1% respectively.

Table 3 Logistic regressions, random-effects regressions, and modified gov-score

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(2009). Based on the ISS governance standards like our governance metrics, Aggarwal et al.’s (2009) index covers 44 governance attributes and is computed as the percentage of the governance attributes that are satisfied. The data for this index is available from 2004 to 2008, allowing us to run additional tests beyond our sample period.18 The regressions yield consistent results, that is, stronger governance is associated with lower CSR. Further, to make Aggarwal et al.’s (2009) index more similar to our governance metrics, we multiply Aggarwal et al.’s (2009) index by 44 to obtain the number of governance standards that are satisfied. This converted index is more similar to our indices, although it is based on fewer governance standards.19 We execute a regression using this converted index and obtain a similar result. Thus, the additional results based on a more recent time period are consistent. Our conclusion holds both in the sample period (2001–2004) and beyond the sample period (up to 2008) and therefore appears to be robust across time. 5.2. Exploring Endogeneity So far, we have assumed that causality runs from governance quality to CSR. An argument can be made that the direction of causality may be reverse, that is, from CSR to governance quality. This argument for reverse is much less plausible for a few reasons. There is no theory that suggests why firms with high CSR would exhibit stronger governance. Second, it is quite challenging to modify a governance structure. Most governance provisions require shareholders’ approval, which takes a great deal of time and effort to secure. CSR investments, by contrast, are much more subject to managers’ control. It is thus much more probable that managers make decisions on CSR investments, while taking governance structure as given. The direction of causality is much more likely to run from governance quality to CSR than vice versa. In any event, we execute a further analysis to minimize the possibility of reverse causality. First, we identify the earliest year in which each firm appears in the sample. Evidently, governance quality in the earliest year could not have resulted from CSR policy in any of the subsequent years, making reverse causality unlikely. We then use governance quality in the earliest year as our instrumental variable and estimate a two-stage least squares (2SLS) analysis. Table 4 displays the regression results. Model 1 is the first-stage regression, where the dependent variable is Govscore. The coefficient of Gov-score in the earliest year is positive and significant, as expected. Model 2 is the second stage regression, where the dependent variable is the CSR score. The coefficient of the Gov-score instrumented from the first stage is 18

Only aggregate governance data are available for Aggarwal et al.’s (2009) index. Also, their index includes fewer governance attributes than ours. As a result, we use their index only as a robustness check for a more recent sample period. 19 To conserve space, the results based on Aggarwal et al.’s (2009) index are not shown but are available upon request. © 2016 Korean Securities Association

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Table 4 Analysis of early governance and two-stage least squares (2SLS) regressions Gov-Score and ISS-Score are constructed based on the governance attributes provided by the Institutional Shareholder Services (ISS). The CSR score is based on the data from the KLD database. The industry dummies are based on the first two digits of the SIC codes. *, **, *** denote statistical significance at the 10%, 5%, and 1% respectively. (1)

(2)

(3)

2SLS First stage Dependent variable

(4)

2SLS

Ln (Gov-score)

Constant

0.985 (7.68)***

Ln (Gov-score)

0.641 (39.11)***

First stage Second stage CSR 0.231 (0.19) –

Ln (Gov-score) 2.468 (26.91)*** –

Second stage CSR 1.904 (1.71)* –

(Earliest Year) Post-SOX (1 after 2002)



Ln (Gov-score)



– 0.751 ( 3.43)***

0.497 (66.22)*** –

– 1.273 ( 7.81)***

(instrumented) Ln (total assets)

0.042 (14.00)***

0.248 (9.97)***

0.053 (22.36)***

0.261 (10.46)***

Leverage

0.091 ( 3.67)***

0.699 ( 3.30)***

0.011 ( 0.52)

0.831 ( 3.66)***

EBIT/total assets

0.033 (1.32)

1.265 (5.97)***

0.296 (1.52)

1.335 (6.34)***

Asset tangibility

0.043 (1.67)*

0.046 ( 0.21)

0.059 (2.89)***

0.063 ( 0.28)

Capital expenditures ratio

0.002 ( 0.07)

0.937 (4.79)***

0.019 (1.06)

0.979 (5.00)***

R&D/total assets

0.069 ( 0.94)

2.773 (4.41)***

0.011 (0.19)

2.597 (4.11)***

Advertising/total assets

0.205 (1.27)

5.681 (4.10)***

0.054 (0.42)

5.927 (4.28)***

Dividend/total assets

0.315 (2.26)**

4.971 (4.16)***

0.213 (1.93)*

5.139 (4.29)***

Industry dummies

Yes

Yes

Yes

Yes

Adjusted R2

33.76%

13.85%

58.18%

13.68%

Shea’s partial R2

31.31%



56.59%



negative and significant. Our 2SLS results are consistent with the results obtained earlier. Therefore, it is much more likely that stronger governance leads to lower CSR investments than vice versa. Second, as a robustness check, we identify an alternative instrumental variable that is correlated with governance quality and yet uncorrelated with CSR, except through governance quality. Our sample period straddles the passage of the Sarbanes-Oxley Act of 2002 (SOX), which introduced a large number of requirements on corporate governance. The enactment of SOX can be regarded as an exogenous shock that improved the quality of corporate governance without directly affecting CSR. We construct a dichotomous variable equal to one after 2002 and zero before 2002. We label this variable “Post-SOX,” which is intended to capture the difference in governance quality before and after the passage of SOX. In Table 4, Model 3 is the first-stage regression where Gov-score is the dependent variable. The coefficient of Post-SOX is positive and significant, indicating that governance quality improved considerably after the passage of SOX. Shea’s partial R2 is 56.59%, showing that our instrumental variable is not weak. Model 4 is the second-stage regression where the 116

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CSR score is the dependent variable. The coefficient of Gov-score instrumented from the first stage is significantly negative. Our 2SLS analysis reveals that stronger governance brings about less CSR investment. Because our 2SLS results are in agreement with our OLS results, our conclusion is unlikely confounded by the endogeneity bias. 5.3. Analysis of the Governance Categories Gov-score consists of eight governance categories, including boards, audit quality, charter/bylaws, director quality, executive compensation, ownership, and state of incorporation. Because corporate governance is complex and diverse, we hypothesize that certain aspects of governance may have more influence on CSR than others. As a consequence, we investigate the impact of each individual governance category on CSR. Table 5 shows the regression results. To prevent multicollinearity, we regress each governance category on the CSR score at a time. The results reveal that four of the eight governance categories are significantly negatively related to CSR, namely board, audit, compensation, and progressive. It appears that the effect of corporate governance on CSR is not driven by only one specific governance category. Rather, it seems to be based on a broad range of governance categories. 5.4. Managerial Implications Our results have a number of implications. First, shareholders should view investments in CSR with caution. Strong governance induces managers to act more in the interest of shareholders. Because we find that strong governance leads to lower CSR investments, it appears that managers tend to over-invest in CSR and are forced to cut back when governance is more effective. Given the prevalence of CSR in recent years and its enormous investments, the general view is that CSR is beneficial. Our study does not necessary show that CSR is detrimental. However, it demonstrates that, left to their own devices, managers tend to over-invest in CSR.20 Second, managers should exercise caution when making CSR investments as well. Our evidence shows that, at least some of the CSR investments may not be necessary. Our results are helpful because they help managers revise their perspectives on CSR investments and enable them to allocate corporate resources more efficiently. Third, for shareholder activists, our results show that the ISS governance recommendations are effective, at least, as far as CSR investments are concerned. A large number of shareholder activists rely on ISS governance recommendations for their activism. We also shed light on what categories of governance have stronger effects 20

It is important to note that, just like any other study based on a large sample of firms, we are able to draw only a general conclusion from the analysis. There is variation across individual firms in terms of motivations behind CSR investments. In spite of our findings, managers of some firms are probably genuinely motivated by a sense of social responsibility when making CSR investments, not by agency problems. Caution should be taken when applying our conclusion to a specific firm individually.

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– – – –









State

Ownership

Compensation

Progressive



Yes Yes 13.64%

Director education

Control variables Industry dummies Adjusted R2

Yes Yes 13.79%

– Yes Yes 12.87%









0.031 ( 0.90) –

Yes Yes 12.87%







0.297 (1.12) –







0.180*** ( 5.69) –



Audit

Charter





0.071*** ( 4.96) –



(4)

(3)

(2)

Board

(1)

*, **, *** denote statistical significance at the 10%, 5%, and 1% respectively.

Table 5 Analysis of governance categories

Yes Yes 12.92%





0.073 ( 1.35) –









(5)

Yes Yes 13.25%



0.110*** ( 3.58) –











(6)

Yes Yes 13.73%

0.093*** ( 5.67) –













(7)

0.017 ( 0.07) Yes Yes 12.83%















(8)

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on CSR than others. These results help shareholder activists formulate their plans for shareholder activism more effectively. Finally, for regulators, our results show that voluntary corporate governance and shareholder activism appear to be effective. Perhaps, regulations aimed at strengthening corporate governance and protecting shareholders might not be as necessary as originally thought. 6. Concluding Remarks Grounded in agency theory, our study seeks to understand the effect of corporate governance on CSR investments. More effective corporate governance forces managers to take actions that maximize shareholders’ wealth. Our empirical evidence appears to be in favor of the agency/over-investment view. Higher governance quality leads to lower investments in CSR. In particular, an increase in governance quality by one standard deviation translates into a 7.16% drop in CSR investments. It appears that shareholders view CSR investments as conferring at least some private benefits to managers. As a result, as governance becomes more effective, managers are forced or are more strongly motivated to substantially cut back on CSR investments. By contrast, the conflict resolution hypothesis, which argues that more effective governance leads to higher CSR, is not supported by the evidence. The fixed-effects and 2SLS analyses also reveal that our conclusion is unlikely confounded by endogeneity. Combining two crucial areas of the literature, that is, corporate governance and corporate social responsibility, our study offers especially interesting evidence that contributes to the debate on the costs and benefits of CSR. Our results should be of particular interest to a broad range of parties including shareholder activists, CSR activists, and regulators, as well as public shareholders in general. References Aggarwal, R., I. Erel, R. Stulz, and R. Williamson, 2009, Difference in governance practices between U.S. and foreign firms: Measurement, causes, and consequences, Review of Financial Studies 22, 3131–3169. Aupperle, K. E., 1991, The use of forced-choice survey procedures in assessing corporate social orientation, In J. E. Post ed.: Research in corporate social performance and policy 12, pp. 269–280 (JAI Press, Greenwich, CT). Aupperle, K., A. B. Caroll, and J. Hatfield, 1985, An empirical examination of the relationship between corporate social responsibility and profitability, Academy of Management Journal 28, 446–463. Barnea, A., and A. Rubin, 2010, Corporate social responsibility as a conflict between shareholders, Journal of Business Ethics 97, 71–86. Bauer, R., K. C. G. Koedijk, and R. Otten, 2002, International evidence on ethical mutual fund performance and investment style, CEPR Discussion Paper 3452. Bebchuk, L. A., A. Cohen, and A. Ferrell, 2009, What matters in corporate governance? Review of Financial Studies 22, 783–827. © 2016 Korean Securities Association

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Becchetti, L., R. Ciciretti, and I. Hasan, 2009, Corporate social responsibility and shareholders’ value: An empirical analysis, Bank of Finland Research Discussion Paper. Borghesi, R., J. Houston, and H. Naranjo, 2014, Corporate socially responsible investments: CEO altruism, reputation, and shareholder interests, Journal of Corporate Finance 26, 164–181. Brammer, S., and A. Millington, 2003, The effect of stakeholder preferences, organizational structure and industry type on corporate community involvement, Journal of Business Ethics 45, 213–226. Brown, L., and M. Caylor, 2006, Corporate governance and firm valuation, Journal of Accounting and Public Policy 25, 409–434. Burke, L., J. M. Logsdon, W. Mitchell, M. Reiner, and D. Vogel, 1986, Corporate community involvement in the San Francisco Bay area, California Management Review 28, 122–141. Carroll, A., 1991, The pyramid of corporate social responsibility: Toward the moral management of organizational stakeholders, Business Horizons 34, 39–48. Cespa, G., and G. Cestone, 2007, Corporate social responsibility and managerial entrenchment, Journal of Economics and Management Strategy 16, 741–771. Cheng, B., I. Ioannou, and G. Serafeim, 2014, Corporate social responsibility and access to finance, Strategic Management Journal 35, 1–23. Chintrakarn, P., P. Jiraporn, and J. C. Kim, 2013, The effect of corporate governance on CEO luck: Evidence from the Institutional Shareholder Services (ISS), Finance Research Letters 10, 169–174. Chung, K. H., J. Elder, and J. C. Kim, 2010, Corporate governance and liquidity, Journal of Financial and Quantitative Analysis 45, 265–291. Cremers, K. J. M., and V. Nair, 2005, Governance mechanisms and equity prices, Journal of Finance 60, 2859–2894. Deng, X., J. Kang, and B. Low, 2013, Corporate social responsibility and stakeholder value maximization: Evidence from mergers, Journal of Financial Economics 110, 87–109. El Ghoul, S., O. Guedhami, C. Y. Kwok, and D. R. Mishra, 2011, Does corporate social responsibility affect the cost of capital? Journal of Banking and Finance 35, 2388–2406. Godfrey, P. C., 2005, The relationship between corporate philanthropy and shareholder wealth: A risk management perspective, Academy of Management Review 30, 777–798. Gompers, P., J. Ishii, and A. Metrick, 2003, Corporate governance and equity prices, Quarterly Journal of Economics 118, 107–155. Goss, A., and G. S. Roberts, 2011, The impact of corporate social responsibility on the cost of bank loans, Journal of Banking and Finance 35, 1794–1810. Jensen, M. C., 2001, Value maximization, stakeholder theory, and the corporate objective function, Journal of Applied Corporate Finance 14, 8–21. Jiraporn, P., and P. Chintrakarn, 2013a, Corporate social responsibility and CEO luck: Are lucky CEOs socially responsible? Applied Economics Letters 20, 1036–1039. Jiraporn, P., and P. Chintrakarn, 2013b, How do powerful CEOs view corporate social responsibility (CSR)? An empirical note, Economics Letters 119, 344–347. Jiraporn, P., J. C. Kim, and Y. S. Kim, 2011, Dividend payouts and corporate governance quality: An empirical analysis, The Financial Review 46, 251–279. Jiraporn, P., J. C. Kim, Y. S. Kim, and P. Kitsabunnarat, 2012, Capital structure and corporate governance quality: Evidence from the Institutional Shareholder Services (ISS), International Review of Economics and Finance 22, 208–221.

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Jiraporn, P., P. Chintrakarn, J. C. Kim, and Y. Liu, 2013, Exploring the agency cost of debt: Evidence from the ISS governance standards, Journal of Financial Services Research 44, 205–227. Jo, H., and M. A. Harjoto, 2011, Corporate governance and firm value: The impact of corporate social responsibility, Journal of Business Ethics 103, 351–383. Johnson, W., and S. Yi, 2014, Powerful CEOs and corporate governance: Evidence from an analysis of CEO and director turnover after fraud, Asia-Pacific Journal of Financial Studies 43, 838–872. Margolis, J., and J. Walsh, 2003, Misery loves companies: Rethinking social initiatives by business, Administrative Science Quarterly 48, 268–305. McGuire, J., A. Sundgren, and T. Schneeweis, 1988, Corporate social responsibility and firm financial performance, Academy of Management Journal 31, 854–872. McWilliams, A., and D. Siegel, 2001, Corporate social responsibility and financial performance: Correlation or misspecification, Strategic Management Journal 21, 603–609. Oh, W. Y., Y. K. Chang, and A. Martynov, 2011, The effect of ownership structure on corporate social responsibility: Empirical evidence from Korea, Journal of Business Ethics 104, 283–297. Orlitzky, M., F. L. Schmidt, and S. L. Rynes, 2003, Corporate social and financial performance: A meta-analysis, Organizational Studies 24, 403–441. Pava, L., and J. Krausz, 1996, The association between corporate social responsibility and financial performance, Journal of Business Ethics 15, 321–357. Preston, L., and D. O’Bannon, 1997, The corporate social-financial performance relationship: A typology and analysis, Business and Society 36, 419–429. Ruf, B. M., K. R. Muralidhar, M. Brown, J. J. Janney, and K. Paul, 2001, An empirical investigation of the relationship between change in corporate social performance and financial performance: A stakeholder theory perspective, Journal of Business Ethics 32, 143–156. Saiia, D. H., A. B. Carroll, and A. K. Buchholtz, 2003, Philanthropy as strategy: When corporate charity “begins at home”, Business and Society 42, 169–201. Scherer, A. G., and G. Palazzo, 2007, Toward a political conception of corporate responsibility: Business and society seen from a Habermasian perspective, Academy of Management Review 32, 1096–1120. Solomon, R., and K. Hansen, 1985, It’s good business, Atheneum, New York. Stanwick, P. A., and S. D. Stanwick, 1998, The relationship between corporate social performance, and organizational size, financial performance, and environmental performance: An empirical examination, Journal of Business Ethics 17, 195–204. Surroca, J., and J. A. Tribo, 2008, Managerial entrenchment and corporate social performance, Journal of Business, Finance, and Accounting 35, 748–789. Teoh, S. H., I. Welch, and C. P. Wazzan, 1999, The effect of socially activist investment policies on the financial markets: Evidence from the South African boycott, Journal of Business 72, 35–89. Verschoor, C. C., 1998, A study of the link between a corporation’s financial performance and its commitment to ethics, Journal of Business Ethics 17, 1509–1516. Waddock, S. A., and S. B. Graves, 1997, The corporate social performance-financial performance link, Strategic Management Journal 18, 303–319.

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Appendix Governance standards included in the construction of the governance score

Governance standards A. Audit 1. Audit committee consists solely of independent outside directors 2. Auditors were ratified at the most recent annual meeting. 3. Consulting fees paid to auditors are less than audit fees paid to auditors 4. Company has a formal policy on auditor rotation B. Board of Directors 1. Managers respond to shareholder proposals within 12 months of shareholder meeting 2. CEO serves on no more than two additional boards of other public companies. 3. All directors attend at least 75% of board meetings or had a valid excuse for nonattendance. 4. Size of board of directors is at least 6 but not more than 15 members. 5. No former CEO serves on board. 6. CEO is not listed as having a “related party transaction” in proxy statement. 7. Board is controlled by more than 50% independent outside directors. 8. Compensation committee is comprised solely of independent outside directors. 9. The CEO and chairman duties are separated or a lead director is specified. 10. Shareholders vote on directors selected to fill vacancies. 11. Board members are elected annually. 12. Shareholder approval is required to change board size. 13. Nominating committee is comprised solely of independent directors. 14. Shareholders have cumulative voting rights to elect directors. 15. Board guidelines are in each proxy statement. 16. Policy exists requiring outside directors to serve on no more than five additional boards. C. Charter/Bylaws 1. A simple majority vote is required to approve a merger (not a supermajority). 2. Company either has no poison pill or a pill that was shareholder approved. 3. Shareholders are allowed to call special meetings. 4. A majority vote is required to amend charter/bylaws (not a supermajority). 5. Shareholders may act by written consent and the consent is non-unanimous. 6. Company is not authorized to issue blank check preferred stock. 7. Board cannot amend bylaws without shareholder approval or can only do so under limited circumstances. D. Director Education

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Appendix (Continued) Governance standards 1. At least one member of the board has participated in an ISS-accredited director education program. E. Executive and Director Compensation 1. No interlocks exist among directors on the compensation committee. 2. Non-employees do not participate in company pension plans. 3. Option re-pricing did not occur within last 3 years. 4. Stock incentive plans were adopted with shareholder approval. 5. Directors receive all or a portion of their fees in stock. 6. Company does not provide any loans to executives for exercising options. 7. The last time shareholders voted on a pay plan, ISS did not deem its cost to be excessive. 8. The average options granted in the past 3 years as a percentage of basic shares outstanding did not exceed 3% (option burn rate). 9. Option re-pricing is prohibited. 10. Company expenses stock options. F. Ownership 1. All directors with more than 1 year of service own stock. 2. Officers’ and directors’ stock ownership is at least 1% but not over 30% of total shares outstanding. 3. Executives are subject to stock ownership guidelines. 4. Directors are subject to stock ownership guidelines. G. Progressive Practices 1. Mandatory retirement age for directors exists. 2. Performance of the board is reviewed regularly. 3. A board-approved CEO succession plan is in place. 4. Board has outside advisors. 5. Directors are required to submit their resignation upon a change in job status. 6. Outside directors meet without the CEO and disclose the number of times they met. 7. Directors term limits exist. H. State of Incorporation 1. Incorporation in a state without any anti-takeover provisions.

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