An Empirical Investigation on the Wealth Protection Function of Corporate Social Responsibility (CSR)

Abstract

The economic consequence of engagement in socially responsible activities on firm valuation is quite a contentious issue. The debate on whether the objective of business is to maximize shareholders’ wealth or to maximize the welfare of society touches upon issues relevant to the long-term sustainability of firms. Businesses are under increasing pressure to act more ethically and responsibly due to the changes in technology, easy access to information, and better awareness of the adverse effects of business operations. Public pressure is mounting for corporate accountability covering all aspects of business operations whether legal, social, moral, governance, or financial by various stakeholders. Consequently, corporations are responding by issuing corporate social responsibility (CSR) related reports and analysts are providing coverage on CSRrelated issues. Increasing number of investors not only evaluate the financial performance of firms but also looking at how corporations are meeting their social responsibilities. Academic literature related to the benefits of CSR engagement suggests two channels: a wealth enhancement function and a wealth protection function. This study empirically investigates the wealth protection channels of CSR. Specifically, three questions are addressed in this thesis in three different essays. The first essay investigates the impact of engagement in CSR and how it affectsthe credit default risk of firms. The second essay explores whether CSR disclosures mitigate stock price misalignment through increased firm-specific information diffusion. The last essay considers whether socially responsible firms develop and sustain social capital through superior business practices and investigates whether this social capital is reflected in the financial statements attested by external auditors. To measure the level of CSR engagement, annual data on CSR-related disclosures of non-financial US firms from 2000 to 2012 was obtained from KLD Research and Analytics Inc. While financial statements, market prices and analysts’ recommendation data was acquired from Thomson Reuters’ DataStream. The data for auditors’ opinions was obtained from Audit Analytics. In addition to the composite measure of CSR using the principle component analysis (PCA) technique, separate measures related to primary and secondary stakeholders are developed to understand whether the impact of CSR is any different based on CSR activities. The empirical findings support the credit protection function of CSR. The empirical results indicate that firms scoring higher on CSR index have significantly lower default risk. However, this negative relationship between CSR and probability-of-default is more pronounced in CSR activities related to primary stakeholders while CSR-related to secondary stakeholders do not have any significant risk mitigation relationship. The second essay provides evidence that firms with higher levels of engagement in CSR activities have higher firm-specific information diffusion through stock prices implying that stock prices of socially responsible firms are less prone to stock price misalignment. Moreover, in line with the legitimacy theory, the size of firms’ plays a negative moderating role in this relationship suggesting that as the size of the firm increases the marginal impact of CSR on firm-specific information diffusion decreases. Furthermore, primary (technical) CSR is found to be significant in the CSRinformation diffusion function and secondary (institutional) CSR has inverse relationship with stock price informativeness. ii The third essay attest the credit protection role of CSR where firms reporting higher on CSR index found to be more likely to receive favorable auditors’ opinion on financial reporting. The empirical findings suggest that as firms increase their engagement in CSR-related activities the accuracy and reliability of their financial reporting also increases which support the existence of social capital related to CSR engagements. The findings of this thesis have policy implications for firm management, especially for smaller firms. This study concludes that investment in CSR provides an important risk mitigation function that acts like an insurance against credit default risk, provides informative stock prices and builds intangible social capital that ultimately benefits various stakeholders of the firm. Management is encouraged to invest in CSR to capitalize on these wealth protection aspects. Furthermore, in the presence of scarcity of funds, management can focus on CSR activities related to primary stakeholders as the risk mitigation benefits from these engagements are more pronounced as compared with investment in issues related to secondary stakeholders. For regulators, the findings of this study can provide a direction for future regulation whereby firms may have disclosure requirements related to CSR issues. By incorporating CSR-related disclosures in the routine filings of reporting firms, regulators make it easier for investors to invest in those companies that are more socially responsible. For investors, risk mitigation is an important function and CSR can play an important role in risk management. Investors would be better off by investing in CSR conscious companies than other companies otherwise equivalent from a risk perspective and investors should view CSR as a pricing factor in their investment decisions.